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RESTORING CONFIDENCE CREATING RESILIENCE

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					RESTORING CONFIDENCE, CREATING RESILIENCE:
 A n I n d u s t r y P e r s p e c t i ve o n t h e F u t u r e o f I n t e r n a t i o n a l
     Financial Regulation and the Search for Stability




                        Institute of International Finance
                                        July 2009
The Board of Directors of the Institute of International Finance (IIF) and the IIF’s Special Committee on
Effective Regulation are pleased to present this Report to the international financial community, and in
particular to the official sector as they move toward a reformed framework of financial regulation.
     This Report sets out a global industry perspective on financial regulation at the national and
international levels and on the reforms being developed under the broad auspices of the G-20 and the
Financial Stability Board (FSB). It draws on the insights and experience of the IIF membership. The IIF
is the premier global association of financial institutions, with over 375 member firms including most
of the world’s largest banks. Our members also encompass a broad range of other financial institutions,
including a growing number of insurance companies, hedge funds, asset management firms, and sovereign
wealth funds.
     Weaknesses and failings in industry practices, and deep flaws in important parts of the market—in
particular the securitization market—contributed to a grave crisis, compounded by gaps and errors in
regulation and supervision and global macroeconomic imbalances.
     Moving toward greater financial stability is essential. Equally essential is that we do so in a manner
that does not inhibit sustainable global growth—and this is necessarily a shared endeavor. The industry
has made significant strides over the past year in addressing the failings revealed by the crisis. With
the leadership of the authorities, important advances have been made in correcting vulnerabilities in
the market, while at the same time, much progress has been made on the development of more robust
regulatory frameworks.
     Lasting stability depends upon the interaction of well-designed regulation and effectively functioning
international markets, the latter exercising discipline on their participants and reinforcing best industry
practices. To bring this about requires, inter alia, reforms to ensure that any firm that is in danger of failing
can exit the market in an orderly fashion—regardless of its size or scope of activities. The objective should
be a system in which such exits would not have undue impact on a more-resilient market infrastructure,
with the burden of loss being appropriately shared by the firm’s investors and creditors (other than those
who are formally protected) and minimizing any residual risk to taxpayers. Such an approach requires
stronger international coordination and better cooperation between supervisors, including better cross-
border crisis management arrangements.
     Regulatory reform should be built on an integrated view of markets and regulation. It should promote
higher levels of risk-adjusted capital than those prevailing in many areas prior to the crisis, as well as
more effective management of liquidity. At the same time, regulatory requirements demand careful
calibration—there are many pitfalls that could hinder recovery, limit expansion of credit to the real
economy, and threaten renewed job creation. These include arbitrary restrictions on firm size or business
models or, conversely, treating certain firms as too big to fail. Good progress has been made: now it is
essential to avoid any rush to regulation without full consideration of the cumulative impact of proposed
changes; care must also be taken not to fragment globalized markets by well-meant but ultimately
counterproductive national measures that are not adequately coordinated or harmonized.
    We have all recognized the need to intensify our work on developing better means of detecting and
reducing systemic risk. By definition this requires a cross-border approach that recognizes systemic risk
may well be a function of the interconnectedness among markets, firms, and products across national
boundaries. Approaches to systemic risk should be built around this fundamental understanding and not
just focused on a limited number of financial institutions. Reinforced regulation on a well-integrated,
globally consistent basis is now, more than ever, of paramount importance.
    In a spirit of shared endeavor this Report sets out, on the one hand, Commitments addressing those
aspects where improvements and enhancements are required of the industry, and on the other, Recom-
mendations outlining the views of the IIF to the official sector as it carries out the next phase of its critical
work.
    The Institute is grateful for member firms’ time and expertise, which has made the development of this
Report possible. A list of Committee members is included.
    We look forward to a continued and deepened dialogue with the official sector as they press forward
with their work to reform the regulatory and supervisory framework and, together with the industry,
develop a more resilient and efficient set of markets and better managed institutions—ultimately
providing for greater financial stability and resilience.




Josef Ackermann                                            Walter Kielholz

Chairman of the Management Board and                       Chairman of the Board of Directors
the Group Executive Committee                              Swiss Reinsurance Company Ltd.
Deutsche Bank AG




William T. Winters                                         Charles H. Dallara

Co-Chief Executive Officer
Investment Bank                                            Managing Director
J.P. Morgan                                                Institute of International Finance
Contents




   Foreword                                                                                                          i

   Board of Directors of the Institute of International Finance (IIF)                                               1

   IIF Special Committee on Effective Regulation                                                                     3

   Executive Summary                                                                                                7


   Introduction                                                                                                     15

1. Importance of Coordination in an International Market                                                            19

2. A Shared Responsibility to Achieve Resilience                                                                    25

3. Achieving Resilience Through the Cycle With Prudential and Accounting
   Standards                                                                                                        35

4. Financial Stability Through Macroprudential Oversight                                                            55

5. Improving Market Infrastructure and Mitigating Risks of Interconnectedness                                       65

6. Resisting Fragmentation of International Markets                                                                 73

7. Cross-Border Crisis Management and Financial Firm Resolution Regimes                                             77

   Commitments and Recommendations                                                                                  83




                                                               Institute of International Finance • July 2009   ■    iii
                            IIF BOARD OF DIRECTORS

                                          Chairman
                                  Dr. Josef Ackermann*
                         Chairman of the Management Board and
                             the Group Executive Committee
                                    Deutsche Bank AG

First Vice Chairman                     Vice Chairman                         Vice Chairman
 William R. Rhodes*                  Roberto E. Setubal*                   Francisco González*
Senior Vice Chairman         President & CEO of Itaú Unibanco                 Chairman and
     of Citigroup                Banco Multiplo S/A and Vice              Chief Executive Officer
                             President of Banco Itaú Holding S/A                  BBVA


                                          Treasurer
                                      Marcus Wallenberg*
                                     Chairman of the Board
                                             SEB


Hassan El Sayed Abdalla                                 Robert E. Diamond, Jr.
Vice Chairman and Managing Director                     President, Barclays Capital and
Arab African International Bank                         CEO, Investment Banking and Investment
                                                        Management
Yannis S. Costopoulos*
Chairman of the Board of Directors                      Roger Ferguson
Alpha Bank A.E.                                         President and Chief Executive Officer
                                                        TIAA-CREF
Ibrahim S. Dabdoub                                      Stephen K. Green*
Group Chief Executive Officer                            Group Chairman
National Bank of Kuwait, S.A.K.                         HSBC Holdings plc

Charles H. Dallara (ex officio)*                         Jan Hommen
Managing Director                                       Chairman of the Executive Board
Institute of International Finance                      ING Group


                                                        Institute of International Finance • July 2009   ■   1
Jiang Jianqing                                     Corrado Passera
Chairman                                           Managing Director and Chief Executive Officer
Industrial and Commercial Bank of China, Ltd.      Intesa Sanpaolo

K. Vaman Kamath                                    Baudouin Prot
Chairman of the Board                              Chief Executive Officer
ICICI Bank Ltd.                                    BNP Paribas

Kang Chung Won                                     Yasuhiro Sato
President and Chief Executive Officer               President & CEO
Kookmin Bank                                       Mizuho Corporate Bank, Ltd.

Walter B. Kielholz                                 James J. Schiro
Chairman of the Board of Directors                 Group Chief Executive Officer
Swiss Reinsurance Company Ltd.                     Zurich Financial Services

Nobuo Kuroyanagi*                                  Andreas Treichl
President & CEO, Mitsubishi UFJ Financial Group,   Chairman of the Management Board & Chief
Inc. & Chairman, The Bank of Tokyo-Mitsubishi      Executive Officer
UFJ, Ltd.                                          Erste Group Bank AG

Gustavo A. Marturet                                Rick Waugh
President                                          President and Chief Executive Officer
Mercantil Servicios Financieros                    Scotiabank

Klaus-Peter Müller                                 William T. Winters
Chairman of the Supervisory Board                  Co-Chief Executive Officer,
Commerzbank AG                                     Investment Bank
                                                   J.P. Morgan
Frédéric Oudéa
Chairman and Chief Executive Officer                Xiao Gang
Société Générale                                   Chairman
                                                   Bank of China
Ergun Özen
President & Chief Executive Officer
Garanti Bankasi A.S.                               Secretary of the Board
                                                   Peter Wallison




*Member of the Administrative and Nominations Committee

2   ■   Restoring Confidence, Creating Resilience
           IIF SPECIAL COMMITTEE ON EFFECTIVE REGULATION


                                            Chairmen

      Mr. Walter B. Kielholz                                 Mr. William T. Winters
 Chairman of the Board of Directors                         Co-Chief Executive Officer,
  Swiss Reinsurance Company Ltd.                                Investment Bank
                                                                   J.P. Morgan

                                   Committee Members

Mr. Mark Harding                                  Mr. Michael Helfer
Group General Counsel                             General Counsel
Barclays PLC                                      Citigroup Inc

Mr. Mike Walters                                  Mr. Simon Gleeson
Group Head of Compliance                          Partner
Barclays Bank PLC                                 Clifford Chance LLP

Mr. Christian Lajoie                              Dr. René P. Buholzer
Head of Group Supervision Issues                  Managing Director
BNP Paribas                                       Global Head Public Policy
                                                  Credit Suisse
Mr. Baudouin Prot
Chief Executive Officer                            Mr. Urs Rohner
BNP Paribas                                       Vice Chairman of the Board of Directors
                                                  Credit Suisse
Mr. Freddy Van den Spiegel
                                                  Mr. Richard Spillenkothen
Chief Economist - Director Public Affairs
                                                  Director, Bank Regulatory Consulting Practice
Chairman of the IIF Steering Group on
                                                  Senior Advisor, Center for Banking Solutions
Regulation and Supervision
                                                  Deloitte & Touche LLP
BNP Paribas Fortis
                                                  Mr. Donald F. Donahue
Ms. Jill Considine                                Chairman and Chief Executive Officer
Chairman                                          The Depository Trust & Clearing Corporation
Butterfield Fulcrum Group

                                                       Institute of International Finance • July 2009   ■   3
Dr. Hugo Bänziger                                  Mr. Roberto E. Setubal
Chief Risk Officer and Member of the                President & CEO, Itaú Unibanco S/A
Management Board                                   Vice President, Itaú Unibanco Holding S/A
Deutsche Bank AG
                                                   Sir Andrew D. Crockett
Mr. Helmut Bauer                                   President
Managing Director                                  JPMorgan Chase International
Regulatory Affairs
Deutsche Bank AG London                            Mr. Kang Chung Won
                                                   President and Chief Executive Officer
Mr. Roar Hoff                                      Kookmin Bank
Executive Vice President, Head of Group Risk
Analysis                                           Dr. Madelyn Antoncic
DnB NOR ASA                                        Managing Director and Senior Advisor
                                                   Lehman Brothers Holding Inc.
Mr. Bjørn Erik Næss
Chief Financial Officer                             Dr. Mark Lawrence
Group Finance and Risk Management                  Managing Director, Mark Lawrence Group
DnB NOR ASA                                        Senior Advisor, McKinsey & Company

Mr. Nasser Al Shaali                               Dr. Philipp Härle
Chief Executive Officer                             Director
Dubai International Financial Center               McKinsey & Company

Mr. Wolfgang Kirsch                                Mr. Saburo Sano
Chief Executive Officer                             Senior Managing Director
DZ BANK AG                                         Mitsubishi UFJ Financial Group, Inc.

Mr. Gregory P. Wilson                              Mr. Daisaku Abe
President                                          Managing Executive Officer, Head of Strategic
Gregory P. Wilson Consulting                       Planning Group, Head of IT, Systems &
                                                   Operations Group and General Manager of
Mr. Stephen K. Green                               Group Strategic Planning
Group Chairman                                     Chief Strategy Officer
HSBC Holdings plc                                  Chief Information Officer
                                                   Mizuho Financial Group, Inc.
Mr. George Theuvenet
Head of International Affairs                      Mr. Nick Collier
European and International Affairs                 Executive Director
ING Group                                          Head of EMEA Government Relations
                                                   Morgan Stanley
Mr. Carlo Messina
Chief Financial Officer                             Mr. Takis Arapoglou
Intesa Sanpaolo Spa                                Chairman of the Board and Chief Executive
                                                   Officer
                                                   National Bank of Greece S.A.
4   ■   Restoring Confidence, Creating Resilience
Mr. Parkson Cheong                            Mr. Nils-Fredrik Nyblaeus
General Manager & Group Chief Risk Officer     Senior Advisor to the Chief Executive Officer
Credit & Risk Management Group                SEB Group
National Bank of Kuwait, S.A.K.
                                              Mr. Daniel Amadieu
Mr. Ibrahim S. Dabdoub                        Senior Advisor to the Chief Risk Officer
Group Chief Executive Officer                  Société Générale
National Bank of Kuwait, S.A.K.
                                              Mr. H. Rodgin Cohen
Mr. Takashi Oyama                             Chairman
Adviser for Global Strategy                   Sullivan & Cromwell LLP
The Norinchukin Group
                                              Mr. Carl Eric Stalberg
Mr. John P. Drzik                             Executive Chairman
President and Chief Executive Officer          Swedbank AB
Oliver Wyman
                                              Mr. Philippe Brahin
Mr. Jean-Pierre Beguelin                      Head of Regulatory Affairs
Chief Economist                               Swiss Reinsurance Company
Pictet & Cie Banquiers
                                              Mr. Steve Hottiger
Mr. John W. Campbell                          Managing Director & Head of Group
Senior Regulatory Services Partner            Governmental Affairs
Advisory Services                             UBS AG
PricewaterhouseCoopers LLP
                                              Mr. Sergio Lugaresi
Mr. Eugene A. Ludwig                          Senior Vice President
Founder and Chief Executive Officer            Head of Regulatory Affairs
Promontory Financial Group, LLC               Institutional and Regulatory Strategic Advisory
                                              UniCredit Group
Mr. Morten Friis
Chief Risk Officer                             Mr. Peter Buomberger
Royal Bank of Canada                          Group Head of Government and Industry Affairs
                                              Member of Executive Staff
Mr. Stephen Sanders                           Zurich Financial Services
Group Head of Regulatory & Operational Risk
Royal Bank of Scotland Group

Mr. Brian J. Porter
Group Head, Risk & Treasury
Scotiabank




                                                    Institute of International Finance • July 2009   ■   5
Executive Summary




               The only sure foundation for sustainable globalization and rising prosperity for all
                is an open world economy based on market principles, effective regulation,
                      and strong global institutions. —G-20, London, April 2, 2009




T
         he crisis that developed two years ago           reduced complexity, which are shared market
         revealed widespread weaknesses in many           goals. Markets worked where assets, procedures,
         financial firms’ business practices, as well       and infrastructure were well-understood. The
as notable deficiencies in market operations. At           industry has made significant progress on
the same time, the crisis exposed misalignments           improving underwriting, documentation, and
and gaps in regulatory and macroeconomic poli-            transparency in securitization markets.
cies. Much progress has been made by the official               This Report reaffirms the commitment of IIF
sector in developing a strengthened regulatory            members to continue raising market practices
framework—one geared more toward containing               to the high standard set out in the July 2008
systemic risk.                                            Final Report of the IIF Committee on Market
     At the same time, the financial industry has          Best Practices (the Market Best Practices Report),
firmly recognized the need for wide-ranging                building on the substantial progress made to date.
improvements in business practices—and has                     The IIF agrees that far-reaching regulatory
made tangible progress on implementation.                 reforms are necessary to guard against systemic
These improvements include significantly                   vulnerabilities, ensure robust markets including
enhanced risk management; more effective                  liquid and transparent asset-backed credit
liquidity management; greater transparency; and           markets, and encourage beneficial innovation.
compensation policies aligned with long-term,             This would also help ensure that the industry
risk-adjusted performance. Deepening these                follows through with its commitments. However,
reforms by the industry is, together with                 it is crucial that the cumulative effects of reform
improved market discipline, a sine qua non                be consistent with market efficiency, avoiding
for greater systemic stability and an essential           rigidities that could stifle growth, job creation,
underpinning to more effective regulation and             and innovation, or increase the cost of financial
supervision.                                              services to customers.
     Asset-backed securities markets have been
damaged by the crisis, even “vanilla” products            1. Importance of Coordination
that were exempt from the problems of resecu-                in an International Market
ritizations. Restoring the critical role of these
markets is essential to a sound recovery and              The G-20 has catalyzed a potentially important
can be achieved by greater transparency and               new level of international coordination. However,


                                                                 Institute of International Finance • July 2009   ■   7
recent developments suggest that there has            strengthened capabilities in risk
nonetheless been “fragmentation” that could           aggregation, improved stress testing,
weaken the capacity of the global economy to          improvement of market-risk management,
return to sustainable growth. It is essential that    and significant investment in risk systems
agreement on the high-level principles of reform      and data.
translate into a high degree of convergence on        Increased and Better Quality Capital
specific regulation. This represents an important      compared to the position prior to the crisis,
challenge for the Financial Stability Board (FSB)     in response to market and official-sector
and other international organizations. The IIF        requirements. The challenge now, for both
is committed to deepening its dialogue on these       the industry and the official sector, is to
issues with the FSB and with each of the interna-     develop an appropriate analysis of the
tional standard-setters.                              levels of capital needed to weather times
                                                      of stress while avoiding overshooting or
2. A Shared Responsibility to Achieve                 misaligned incentives and assuring that
   Resilience                                         financial stability is balanced with objec-
                                                      tives for economic growth.
Lasting financial stability depends on the effective   Better Liquidity Risk Management,
interaction of markets, firms, and regulation.         including more robust analysis of funding
Stability will not be achieved by reliance on one     needs and sources, wide application
without the others. All must work in concert to       of stress-testing techniques, and more
achieve resilience, stability, and the efficiency      substantial liquidity buffers.
necessary to support sustainable global growth.       Reducing Procyclicality by analyzing its
                                                      causes, refining provisioning practices, and
The Industry’s Demonstrated Commitment                making more extensive use of “through-
to Change                                             the-cycle” approaches to capital.
Fundamental questions about the pre-crisis            Reducing Leverage, both on a systemic
business conduct of many financial firms have           and individual-firm basis, based on a
damaged the industry’s credibility. Strengthening     clear recognition of the negative effects of
the ability of firms, market infrastructure, and       excessive leverage.
markets themselves to withstand stress and            Material Improvement on Disclosure and
cyclical downswings is essential. The industry        Transparency through Pillar 3, together
reaffirms its commitment to strengthening all          with Industry Initiatives to Reform Securi-
lines of defense to achieve long-term stability and   tization, working toward more trans-
to restore the health of the sector and the global    parent, liquid, and standardized markets,
economy.                                              and also clarifying firms’ Off-Balance
     While significant advances are being made,        Sheet Exposures.
much work remains to be done by the industry          Significant Reforms of Compensation
to act on lessons learned in critical areas. The      Practices to align them with long-term
industry has made substantial progress on, and        shareholders’ interests and firm-wide
is committed to, the following:                       profitability, taking account of overall risk
                                                      and the cost of capital. The IIF reaffirms
        Materially Improved Risk Management,          the wide commitment to implementation
        including more robust risk governance,        of the Compensation Principles set out
                                                      in the Market Best Practices Report and



8   ■    Restoring Confidence, Creating Resilience
      welcomes the FSB Principles for Sound                       Regulation needs to operate in tandem with
      Compensation Practices.1                                meaningful market discipline. For markets to
      Development with the official sector of a                discipline firms effectively, it must be possible for
      Better Understanding of the Sources and                 firms to exit the market in an orderly manner,
      Mitigants of Systemic Risk, using this                  whatever their size or degree of interconnect-
      understanding in risk management, and                   edness, with consequences for creditors and
      working with the official sector on macro-               investors.
      prudential means through which it can be
      identified, addressed, and mitigated.                    Withdrawal Strategies—Restoring Normal
      Significantly enhanced risk management,                  Markets
      processing, transparency, and systems
                                                              While public interventions to secure stability
      and market infrastructure for carrying on
                                                              have been necessary, it is necessary now for
      Credit Default Swaps (CDS) and other
                                                              governments, central banks, and regulators to
      Over-the-Counter (OTC) Derivatives
                                                              develop clear strategies for withdrawal from
      business.
                                                              their emergency interventions so as to avoid
                                                              competitive distortions and restore an effectively
    The IIF’s Market Best Practices Report,
                                                              functioning marketplace.
together with reports such as the Senior
Supervisors Group Report,2 have become
benchmarks for large international firms. The                  3. Achieving Resilience Through
industry welcomes the use of these reports in                    the Cycle With Prudential and
the supervisory assessment of the quality of risk                Accounting Standards
management of firms. It would also be beneficial
                                                              Current capital, liquidity, and accounting require-
to arrange an annual review involving authorities
                                                              ments need to be better adapted to times of stress
and firms collectively to consider trends, progress,
                                                              or economic downturn. Measures need to be
and shortcomings across the financial sector.
                                                              taken to reduce procyclicality. Revised standards
                                                              need to be implemented through strong interna-
Effective Regulation, Enhanced Supervision,
                                                              tional coordination.
and Meaningful Market Discipline
                                                                  Overall levels of capital relative to pre-crisis
Better regulation requires clear objectives, good             levels need to be increased within the framework
dialogue, and robust impact assessment, while the             of a revised Basel II risk-based approach; capital
best supervisory response to the crisis is a more             must also respond to system-wide cyclical risks
rigorous, outcomes-focused approach providing                 and times of stress. Resources must be built up
clear incentives to strong risk management. Firms             in good times that are genuinely able to be drawn
must ensure that their interaction with regulation            upon when needed, and the quality of capital
and supervision is positive and non-defensive.                needs to be reviewed. International consistency
Better regulation requires clear objectives, good             in interpretation of capital rules is needed. There
dialogue, and robust impact assessment.                       will be a continuing important role for Tier 2
                                                              capital.
1 FSB Principles for Sound Compensation Practices, April 2,       Leverage in the system was too high and
2009.                                                         needs to be kept under control in the future.
2 Senior Supervisors Group Report, Observations on Risk
                                                              Focus on leverage as a backstop to capital
Management Practices during the Recent Market Turbulence,
                                                              requirements makes sense—provided there is
March 6, 2008.
                                                              worldwide consistency—but the IIF counsels


                                                                     Institute of International Finance • July 2009   ■   9
against hardwired “Pillar 1” ratios, which do not     Cumulative Effects, the Cost of Error,
take into account actual portfolio composition        and Timing
and may create misaligned incentives. More
                                                      Conservatism in the design of the new regulatory
nuanced leverage indicators should figure in the
                                                      regime is appropriate to allow for uncertainty
Pillar 2 supervisory review process.
                                                      and unknowns. Nonetheless, material error in
     A comprehensive, high-level dialogue on
                                                      the calibration of new prudential requirements
current accounting standards in light of the
                                                      would have major negative effects, not just on the
crisis, involving all relevant parties, remains
                                                      financial industry but on national economies—
essential. The most critical need is rapid conver-
                                                      and ultimately on the global economy.
gence of international standards as mandated by
                                                           It is sometimes overlooked in discussions of
the G-20. Work currently in progress to review
                                                      remedies that generation of reasonable returns
fair-value and accrual accounting for financial
                                                      is the foundation of firms’ viability and ability
institutions should continue with urgency.
                                                      to meet clients’ financial needs—and thus to
Authoritative guidance should be issued to allow
                                                      stimulate economic activity. Although it has in
the use of reasonable interpretation in assessing
                                                      certain cases been abused, innovation remains
loan loss provisioning under the incurred-loss
                                                      essential to future progress, in a context of
model, pending the in-depth review of provi-
                                                      stronger risk management, good governance,
sioning (which itself is a high priority).
                                                      and effective supervision. Care must be taken to
     The IIF has argued that local self-sufficiency
                                                      preserve the benefits of positive innovation.
or stand-alone approaches to liquidity regulation
                                                           All practicable steps should be taken to
should be resisted. While acknowledging local
                                                      assess the cumulative impact of proposed
market liquidity needs, the drain on systemic
                                                      measures, to consider their effect on the avail-
resilience created by “trapped pools of liquidity”
                                                      ability of credit and other financial resources
must also be recognized. Any new liquidity
                                                      to the wider economy, and to calibrate the new
regulation will be counterproductive unless inter-
                                                      measures as accurately as possible. If not well
nationally coordinated. It is of course necessary
                                                      assessed, the burdens on intermediation can
to hold adequate liquidity buffers; however, overly
                                                      become so great that global economic activity
mechanistic approaches, including mandatory
                                                      is materially adversely affected, with additional
core-funding ratios, should be avoided.
                                                      costs to consumers and businesses, increased
     Simpler, more-transparent securitizations,
                                                      unemployment, and overall negative impacts
based on good underwriting and improved
                                                      on welfare. The IIF recognizes the challenges of
transparency, are essential to restoring the flow of
                                                      carrying out such assessment and offers to work
credit to important consumer sectors. Industry
                                                      with the regulatory community on objective
work on the needed improvements continues.
                                                      analysis of the cumulative net impact of
It is equally essential that regulatory and
                                                      proposed regulatory changes.
accounting changes foster the return of robust
                                                           Proposals need to be produced, agreed upon,
securitization markets.
                                                      and implemented in a timely manner. However,
     The development of a comprehensive global
                                                      time is needed to ensure the appropriate
standard for the supervision and regulation
                                                      design, assessment, and calibration of new and
of internationally active insurance firms on a
                                                      often radical proposals. The dangers of rushed
group-wide basis is urgently needed. Interna-
                                                      regulation must be avoided. In order not to
tional solvency standards need to be developed, as
                                                      compound short-term procyclical effects, the
do effective colleges of supervisors for insurance
firms.



10   ■   Restoring Confidence, Creating Resilience
introduction of any new measures needs to be           market discipline, enforced by a real risk of
carefully timed to avoid inhibiting economic           loss by their investors and creditors (other than
recovery.                                              depositors and policy holders). Accordingly, it
                                                       should be a priority to implement the infrastruc-
4. Financial Stability Through                         tural, legal, and process reforms necessary to
   Macroprudential Oversight                           ensure that all firms can exit the market in an
                                                       orderly fashion and without causing a systemic
The IIF agrees that all market participants            crisis, regardless of their size, nature, or range of
whose activities could materially affect systemic      activities. No firm should be considered “too big
stability should fall within the framework of          to fail.”
macroprudential oversight, including all signif-           Given this objective, the ongoing dialogue
icant financial markets, products, and risks.           between large firms and the authorities should
    It would be a mistake, however, to create          include consideration of all the information
formal or public categories of firms subject to         necessary to plan for the orderly exit of the firm
separate systemic regulation. To do so would           should that prove necessary. While some have
run counter to the multifaceted and quickly            suggested firms make “wills” to be used in case of
evolving nature of systemic risk. It would give rise   their failure, it is more likely to be productive for
to a mistaken sense that systemic risk had been        firms to examine with the authorities the risks
corralled within such a category of firms and           that their roles in markets and products create—
would distract from the real problem of identi-        to help the authorities assess what would happen
fying risk in the interaction of firms, markets,        in event of their failure. Such a dialogue would
and products. Further, it would incentivize risk       need to be carried out in confidence between
migration and opacity, creating market distor-         the firm and its relevant authorities. Mitigating
tions and moral hazard. That said, supervisors         actions can then be taken to the degree regulators
should take into account the varying degrees           deem necessary.
of systemic relevance or interconnectedness                Any new regulations and the overall new
of different firms in carrying out risk-based           regime need to be appropriately differentiated
supervision.                                           and risk based. Lines of business such as banking
    Restricting the size or activities of banks or     and insurance can share exposures to similar risks
other financial firms will not provide effective         and yet exhibit real differences that should be
protection against systemic risk, which has been       reflected in the regulatory approach.
triggered by firms of many different shapes and             The IIF’s recently-established Market
sizes. More importantly, systemic risk does not        Monitoring Group (MMG) is committed to
reside in single entities but in the interconnect-     identifying and assessing emerging vulnerabilities
edness of firms, markets, and players. Artificial        and potential dynamics in the markets giving rise
restrictions on size are likely to produce material    to systemic risk, and to dialogue on developments
distortions and unmanageable risk patterns             of concern with the official sector.
within the system.
    Large institutions play an important role in       5. Improving Market Infrastructure
supporting the global economy. They must be
                                                          and Mitigating Risks of
required to meet the highest standards of risk
management and corporate governance and                   Interconnectedness
be subject to appropriately intensive risk-based       The global financial services system has become
supervision. They must be subject to meaningful        highly interconnected. This has brought many



                                                            Institute of International Finance • July 2009   ■   11
benefits—but also brings significant risks. The IIF     a reinvigorated global economy. Fragmentation
regards it as important that measures be put into     of the international market would make financial
place that will retain the benefits of an intercon-    stability oversight more difficult to achieve.
nected and sophisticated global financial system           Fighting fragmentation should be a key part
while reducing the associated risks. Particular       of the FSB’s mandate. Measures should be taken
enhancements are needed to ensure the resilience      to address the confidence deficit that motivates
of the system when facing the failure of a major      inward-looking, nationally driven, and uncoor-
participant.                                          dinated responses. Significantly strengthened
     For this to be accomplished, it is important     frameworks for cross-border crisis management
to be clear about what went wrong and what did        and financial firm resolution are as important
not. Many parts of the system, including equities     as regulatory convergence. A non-binding, inter-
markets and payment, clearing, and settlement         governmental financial services accord should be
systems, performed robustly. In addition, many        established to provide a firm new footing for
derivatives markets, including settlement for         cross-border collaboration and confidence.
credit derivatives, performed well despite difficult
conditions.                                           7. Cross-Border Crisis Management
     However, it is necessary to reduce the              and Financial Firm Resolution
opacity of transactions and of counterparty risk
                                                         Regimes
exposures in the CDS and certain other OTC
markets. In line with the commitments already         Confidence in the ability of the system to deal
made by industry, all eligible standardized           effectively with cross-border crises and to
transactions should be cleared through a              manage the orderly exit of a large cross-border
central counterparty (CCP). It is important that      financial institution is basic. Such confidence,
end-users remain able to use these tools to hedge     or its absence, has a fundamental impact on the
against specific situations. Accordingly, standard-    way firms and markets are regulated and on how
ization should not be pursued to the extent that      authorities cooperate in the ongoing supervision
it eliminates the flexibility achievable through       of international firms. The FSB should, as a
bespoke transactions.                                 priority, develop a convention on cross-border
     Authorities’ intervention in the area of         crisis management. Cross-border crisis simulation
market infrastructure needs strong global             exercises should be carried out regularly. Burden-
coordination. Market infrastructure is highly         sharing agreements are needed, based on criteria
international in nature, so artificial distinctions    established by the FSB.
across borders are likely to invite arbitrage and          Authorities should have in place special
create market distortion.                             regimes for bank resolution, including power
                                                      of early intervention; making the protection of
6. Resisting Fragmentation of                         the financial system a primary objective; and
   International Markets                              ensuring alignment with financial-markets law
                                                      (for example, settlement finality, set-off, and
Some responses to the crisis are having a             collateral rights). Any winding up of a cross-
“fragmenting” effect on the market. An open           border financial firm should aim to maximize the
question is whether the long-term legacy of           outcomes for creditors of the group as a whole
the crisis will be protective retrenchment or a       without discrimination between creditors by
more positive, international regime creating a        nationality or location.
robust and stable financial services platform for



12   ■   Restoring Confidence, Creating Resilience
Conclusion                                               Regulation needs to be enhanced in scope,
                                                     impact, and quality, and should be extended to
Effective regulation and effective markets are
                                                     address systemic stability risk. However, the cost
interdependent. Markets in financial services
                                                     of materially misjudged or inefficient regulation
must be made to work more effectively than they
                                                     will have sustained adverse effects. It is essential
have previously. Transparency must be improved.
                                                     that regulatory reform be implemented on the
Incentives must be better aligned. Creditors must
                                                     basis of an integrated regulatory and market
be at risk in order to bring a much more effective
                                                     perspective, a robust assessment of cumulative
market discipline to bear.
                                                     impact, a risk-based approach, international
                                                     coordination, and effective dialogue.




                                                          Institute of International Finance • July 2009   ■   13
Introduction




A
          year ago the IIF published the Final              improvements but how to make the structural
          Report of the IIF Committee on Market             and regulatory changes necessary to ensure that
          Best Practices3 (“Market Best Practices           the likelihood of such systemic events in the
Report”), which provided a frank analysis of                future is significantly reduced.
the failings and weaknesses in many firms’                       A number of reports have appeared over
practices leading up to the recent financial                 recent months addressing the question of how
crisis. The Report set out clear and detailed               financial regulation and market functioning
recommendations for firms’ governance,                       should be reformed to seek to avoid a recur-
business practices, and day-to-day risk                     rence of the events of the past two years.4
management.4                                                Taken together, these reports represent a
     The analysis and recommendations                       major achievement. Developed over a short
contained in the Market Best Practices Report               period of time, the reports identify, elaborate,
remain centrally important. They support                    and provide the necessary framework for
demonstrated progress and a continuing                      consideration of most of the central issues to be
effort across the industry to reform how                    determined over the period to come.
it does business, including with respect to                     The present Report seeks to address a
corporate governance, risk management, and                  number of the issues that are raised in those
compensation. The IIF membership reaffirms                   reports and are currently under wide consider-
its commitment to the implementation of the                 ation. It attempts neither to be comprehensive
recommendations set out in the 2008 report.                 nor to present detailed views on issues where
     It is now clear, in light of the traumatic             others are better placed to develop the necessary
events of the intervening 12 months, that the               analysis and propose solutions. Rather, it has
roots of the problem were more profound than                the objective of putting forward an industry
previously had been understood. The question                perspective on a relatively few themes where
now is not simply how to make necessary                     decisions made now will have a formative

3Final Report of the IIF Committee on Market Best Practices, July 17, 2008, http://www.iif.com/regulatory/cmbp.
4These include G-20 Declaration on Strengthening the Financial System, April 2, 2009, together with its Working
Groups’ reports Enhancing Sound Regulation and Strengthening Transparency, March 25, 2009, and Reinforcing
International Cooperation and Promoting Integrity in Financial Markets, March 27, 2009; the Geneva report on
the Fundamental Principles of Financial Regulation, July 2, 2009; the Group of Thirty report Financial Reform: A
Framework for Financial Stability, January 15, 2009; the report of the de Larosière High-Level Group on Financial
Supervision in the EU, February 25, 2009; the Turner Review: A Regulatory Response to the Global Banking Crisis,
March 18, 2009; the U.S. Treasury proposals for financial regulatory reform A New Foundation: Rebuilding
Financial Supervision and Regulation, June 17, 2009; and most recently the UK Treasury document Reforming
Financial Markets: Impact Assessment, July 8, 2009.

                                                                  Institute of International Finance • July 2009   ■   15
impact on global economic well-being for a          formal, or bright-line, categories but rather is
long time to come.                                  a multifaceted and dynamic concept that must
     Section 1 considers the benefits of inter-      be addressed by comprehensive oversight and
national financial markets and the importance        review at the macrolevel and sophisticated risk-
of cross-border coordination and cooperation.       based supervision at the microlevel. It argues
It reemphasizes the important role of the           that seeking to address the problem by artificial
expanded Financial Stability Board (FSB)            restrictions on firms’ size or activities is likely
and international standard-setters. It sets out     to fail and to do harm, and that instead what
the need to take all the measures necessary to      is required is a matrix of measures to protect
ensure the effectiveness and appropriate consis-    against systemic risks.
tency of international colleges of supervisors           Section 5 addresses systemic issues
for cross-border groups. It also identifies the      associated with market infrastructure and the
need for international solvency standards for       high degree of interconnectedness in financial
insurance firms.                                     markets. It supports the advances achieved, and
     Section 2 discusses the shared respon-         further commitments made, by the industry
sibility of the industry and regulators for         in the curtailment of counterparty risk arising
achieving high levels of confidence and resil-       from credit default swaps (CDS) and other
ience in the international financial system. It      over-the-counter (OTC) markets and in the
considers the need for the industry to improve      introduction of significantly enhanced trans-
its practices and the strong progress already       parency to support a more-liquid and simpler
made, the dual responsibility of firms and           securitization market for the future. It also
supervisors to achieve high-quality supervisory     draws attention to those important parts of
outcomes, the importance of ensuring that           the market infrastructure that demonstrated
regulation is effective and efficient to maximize    considerable resilience during even the deepest
social outcomes, and the need for markets to        point of the crisis.
perform effectively to underpin resilience and           Section 6 identifies the growing threat of
confidence. This requires that firms be allowed       fragmentation of international markets. It
to fail and then exit the market in an orderly      notes that to a certain extent this represents a
manner.                                             comprehensible reaction by authorities to the
     Section 3 deals with reform of prudential      crisis. However, it calls for a forward-looking
and accounting standards, in particular to          reinvigoration of international markets and not
ensure resilience of the system throughout the      a backward-looking retrenchment that will lead
economic cycle. Reform and enhancement are          to lesser outcomes for all. It suggests ways in
necessary across a significant number of areas.      which this reinvigoration can be achieved.
However, it is important that such reform be             Section 7 deals with the key topics of cross-
well-coordinated internationally, based on a        border crisis management and financial firm
clear understanding of the likely impact and        resolution regimes. To a material extent, the
cost, come from an integrated view of all the       way with which cross-border crises and bank
different moving parts, and remain risk based.      failures are dealt determines how international
     Section 4 considers financial stability and     coordination and cooperation function during
macroprudential oversight. It considers the         the ongoing life of a cross-border financial
thorny question of systemic relevance and           services firm. It is clear that there have been
concludes that this cannot be captured by           significant weaknesses in the way in which




16   ■   Restoring Confidence, Creating Resilience
both crisis management and firm failures have       financial services and insolvency legislation. The
been managed. This is to a significant extent due   section identifies the need for improvement in
to problems deriving from the national basis of    these areas and puts forward suggestions.




                                                        Institute of International Finance • July 2009   ■   17
 SECTION 1

Importance of Coordination in an International Market




T
        he G-20 agreed in London in April “to es-     basis for new levels of global economic growth,
        tablish the much greater consistency and      which has delivered improved economic condi-
        systematic cooperation between countries,     tions for many individuals in many countries.
and the framework of internationally agreed high           Cross-border financial groups play a
standards, that a global financial system requires.”   critical role in the efficient allocation of capital.
    The IIF welcomes this commitment. It is           Moreover, during country-specific crises, the
important that firms be able to operate effectively    “internal markets” of cross-border groups have
and efficiently across borders and to avoid            shown themselves helpful to mobilizing resources
material regulatory divergence, both jurisdictional   in circumstances where external markets may
and sectoral.                                         be less available. Therefore, cross-border groups
    With the great array of regulatory proposals      that are able to manage their liquidity and capital
that are currently under consideration, it is         prudently on a group-wide basis are likely to act
essential that authorities carry through with a       as a material source of systemic stability. They are
strong commitment to coordinate their actions.        in a position to leverage the flexibility and resil-
                                                      ience of the group to deliver liquidity and capital
1.1. BENEFITS OF INTEGRATED                           where and when it is needed.
     FINANCIAL MARKETS AND
     CROSS-BORDER INSTITUTIONS                        1.2. POSITIVE STEPS
A globalized financial system:                         In line with the commitment of the G-20, much
    1. Provides savers and users of funds the         progress has been made in the coordination of
       greatest choice in terms of portfolio          cross-border regulatory reform.
       allocation and financing options;                    The industry warmly welcomes the broadened
    2. Enables the efficient transfer of funds         mandate of the FSB to include not only assessing
       from countries with “excess” savings           vulnerabilities and promoting coordination and
       to locations in need of capital for            information exchange among authorities respon-
       investment; and                                sible for financial stability, but also coordination
    3. Provides financial firms with the flexibility     of international standard-setting bodies, setting
       to determine the scale, scope, and reach of    guidelines for supervisory colleges, and managing
       their intermediation operations, including     contingency planning for cross-border crisis
       to emerging markets.                           management.
                                                           Financial markets play an essential role in
    An increasingly integrated financial market        supporting global markets. Strong, sustainable
has, over the past 20 years, provided an important    growth across the world depends on financial
                                                      markets that are increasingly integrated, regulated


                                                           Institute of International Finance • July 2009   ■   19
consistently, and capable of marshaling private       balanced sense of priorities from host supervisors.
credit for investment needs as they arise.            To some extent, this reflects the fact that colleges
                                                      are based purely on good intentions among their
1.3 IMPORTANCE OF COLLEGES                            participants and lack a clear legal foundation, at
                                                      least outside the EU, once current proposals are
A further welcome decision is the establishment       implemented.
of colleges of supervisors for all major interna-          To achieve the kind of results that the G-20
tional financial firms. The concept of colleges is      expects from colleges, the role of the FSB in
a powerful one and, properly executed, colleges       insisting on coordinated, consistent, and well-
working with individual firms can do a great           directed operation by colleges will be essential.
deal to advance the goals of coordination and         The IIF welcomes the commitment of the FSB,
convergence of regulation and cooperation             in its press release of June 27, 2009, that it “will
among supervisors. Moreover, they can facilitate      set guidelines for and oversee the establishment
a substantial increase in supervisory efficiency       and effective functioning of supervisory colleges,
as well as effectiveness by aligning the efforts of   and will monitor and advise on best practice
multiple supervisors; allocating responsibilities     in meeting regulatory standards with a view
among them; avoiding duplication of effort;           to ensure consistency, cooperation and a level
developing better and more consistent infor-          playing field across jurisdictions.”
mation for both home and host supervisors about            In the medium term, it is likely that the FSB
large groups; establishing common reporting           and the G-20 will find it necessary to request
formats and requirements for firms; coming to          that states give their supervisors a clear mandate
common decisions about important matters such         to act on a basis of international cooperation, as
as the Pillar 2 Supervisory Review Process; and       well as on the basis of their traditional national
assessing overall regulatory effectiveness.           mandates, to achieve good results. The G-20
     As discussed in Section 4, well-functioning      took a step in this direction by agreeing that all
colleges of supervision can also play an important    regulatory authorities ought to have a financial
role in implementing the microprudential aspects      stability mandate; a similarly agreed mandate
of macroprudential oversight.                         for international cooperation would make
     Parts of the G-20 mandate implicitly expand      sense.
the remit of colleges. For example, supervision
of liquidity risk management in large firms will        Commitment I: The IIF membership will
certainly need to be coordinated through colleges.     dedicate the necessary resources and engage
     On their side, firms need to dedicate resources    with their colleges of supervisors on a high-
and ensure they engage with their colleges on          priority, fully committed basis.
a fully committed basis. Yet effectiveness is a
two-way street. Firms’ investment of time and          Recommendation 1: The FSB should proceed
resources in working with colleges depends on          quickly and with continued determination in
making the productivity of the process fully           taking the steps necessary for the establishment
evident. Here, it must be recognized that firms’        and operation of well-functioning colleges
experiences with colleges previously organized for     of supervisors for internationally active
Basel II purposes has been decidedly mixed. Some       banks. Ensuring effectiveness, high-quality
have usefully increased supervisory efficiency,         cooperation, and appropriate consistency in
clarity, and consistency, but this has not always      the operation of these colleges should be a
been the case.                                         high-priority task for the FSB and supervisory
     Colleges impose a significant burden on the        authorities.
home supervisor and require cooperation and a

20   ■   Restoring Confidence, Creating Resilience
1.4 ENHANCED SIGNIFICANCE OF                             Added Roles of the International
    INTERNATIONAL STANDARD-                              Organization of Securities Commissions
    SETTERS                                              The crisis has raised issues of market and
                                                         conduct-of-business regulation as well as
The new role of the FSB does not diminish, and
                                                         prudential regulation. The International Organi-
indeed should enhance, the importance of the
                                                         zation of Securities Commissions (IOSCO) has
role of the Basel Committee and other standard-
                                                         done fine work over the years in developing
setters that participate in the FSB. Their task
                                                         internationally recognized standards for securities
becomes more important—and more complex—
                                                         regulation as well as effective models for cooper-
because of their expansion to include additional
                                                         ation on information sharing and enforcement.
major economies, but the substantive importance
                                                             As it has become clear that market regulation
of their tasks is all the more important as well.
                                                         has an effect on systemic stability as well as
Achievement of convergence and consistency, at a
                                                         prudential regulation and solvency requirements,
practical as well as a theoretical level, is essential
                                                         the role of IOSCO will necessarily grow.
to a well-functioning future financial system that
                                                             Matters such as hedge fund regulation,
will be free of regulatory arbitrage and unfair
                                                         regulation of credit-rating agencies, product
anomalies or vulnerability-creating loopholes.
                                                         transparency, and the like all too easily lead to
                                                         national deviations or are based on as-yet unrec-
Basel Committee Leadership
                                                         onciled national traditions. The recent experience
As the discussions of capital and related matters        with uncoordinated short-selling regulations
in Section 3 make clear, the Basel II Accord             shows clearly the need for international coordi-
remains absolutely essential to the future               nation in the securities sector, a need IOSCO fully
soundness of firms and the resilience of the              recognizes.
system. Getting the planned changes right is of              In addition to attending to specific regulatory
the greatest importance, as is the need for timely       issues, IOSCO has the opportunity to contribute
and consistent implementation of the Accord              to enhanced cross-border cooperation.
across all major jurisdictions, including the            In particular, the IIF welcomes the recent
United States. It will be most important if the          statement of Jane Diplock, Chair of its Executive
G-20’s coordination mandate is to be carried out         Committee, calling for the renewal of discus-
for the Basel Committee to maintain leadership           sions on mutual recognition between securities
on capital, leverage, and similar issues.                authorities as well as the Committee of European
    Substantively, the international consistency         Securities Regulators’ (CESR) consultation paper
and level playing field that only the Basel               on the topic.5
Committee can achieve will be absolutely
essential to international stability. The origins
of the Basel process show incontrovertibly the
dangers of international capital divergence. As
discussed further in Section 6, those dangers are
today real. Keeping the Basel Committee in the
lead on these processes—and avoiding front-              5 Jane Diplock, Speech at Centre for European
running by individual jurisdictions that may             Policy Studies, Brussels, April 22, 2009; CESR: Call
become impatient with the process—will be one            for Evidence on Mutual Recognition With Non-EU
of the FSB’s and G-20’s most important tasks.            Jurisdictions, June 8, 2009.



                                                              Institute of International Finance • July 2009   ■   21
                                                      essential. Therefore, current efforts on regulatory
 Recommendation 2: National authorities               reform should give impetus to the development
 should coordinate closely in respect of the wide     of an international regulatory standard on
 array of regulatory proposals that are currently     solvency for insurance companies, which could
 under consideration, working through the             be based on the original proposals for the EU
 relevant international standard-setting bodies.      Solvency II directive (including strong group-
 Such coordination should go beyond the level         supervision provisions).
 of principle or direction and ensure consistency          The International Association of Insurance
 of specific regulation. There should be timely        Supervisors (IAIS) is well placed to take up this
 and consistent global implementation of Basel        task provided that there is commitment from
 II, appropriately modified. Coordination              all major jurisdictions. The IIF membership
 becomes increasingly important given emerging        is committed to playing a responsible and
 fragmentation.                                       constructive part in this dialogue.

                                                          Recommendation 3: A global framework
                                                          for the supervision and regulation of
1.5. TIME TO MOVE TO
                                                          internationally active insurance firms on a
     INTERNATIONAL SOLVENCY                               group-wide basis should be developed under
     STANDARDS FOR INSURANCE                              the leadership of the IAIS.
While it is evident and reasonable that insurance
regulation has not been an area of focus during
the crisis, this does not mean that policymakers      1.6. TROUBLING DEVELOPMENTS
should miss this opportunity to address what
is perhaps the key priority area on insurance         The G-20 stated in London that any retreat
regulation: a global standard for the supervision     into financial protectionism, and in particular
and regulation of internationally active insurance    measures that constrain worldwide capital flows,
groups on a group-wide basis.                         should be avoided. Unfortunately, recent months
    In this Report we have analyzed in detail the     have seen a growing number of measures, the
issue of how to promote an effective framework        effect of which is to cause fragmentation of the
for the supervision of internationally active         international market along national boundaries.6
financial firms. In insurance, despite the efforts by       The attachment of explicit or implicit
a number of jurisdictions to organize meaningful      domestic lending requirements to government
colleges for international firms, the results have     assistance betrays a strong and troubling tendency
been less than optimal. Without a common              to home bias. Measures based on self-sufficiency
framework, efforts by supervisors from different      concepts designed to increase the protection of
jurisdictions are focused on their own territories,   domestic stakeholders even though the effects
and much remains to be done to develop a              on the global system are negative are equally
comprehensive, meaningful, and effective super-       troubling. This issue of fragmentation is discussed
visory arrangement for an international insurer.      in more detail in Section 6.
    Insurance supervisors continue to work
                                                      6 For a more detailed elaboration of different
through a patchwork of different regulatory
systems. This situation ought to change. The          fragmenting measures of recent months, see recent
financial crisis has made it evident that truly        IIF Staff Paper, Fragmentation of the Financial System:
                                                      Analysis and Recommendations, June 11, 2009, http://
international approaches to regulation are
                                                      www.iif.com/regulatory/article+363.php.


22   ■   Restoring Confidence, Creating Resilience
1.7. NEED FOR WITHDRAWAL                                as discussed further in the Market Best Practices
     STRATEGIES                                         Report, it will be important to design rather
                                                        broader, more-uniform collateral and other
While government interventions to secure                policies for the central banks’ regular role in
stability over the recent period have been              money markets in the new regime. Formalizing
welcome and important, it is necessary now to           emergency liquidity and collateral policies for
develop withdrawal strategies for governments           future use should also be part of the withdrawal
to exit their holdings in financial firms. Well-          process.
formulated and executed plans in this regard are            It will be important for both normal and
essential to avoid competitive distortions and          emergency policies to be internationally harmo-
ensure a level playing field both within and across      nized and coordinated to the maximum extent
countries and to restore an effectively functioning     possible. Definition of new central bank policies
marketplace.                                            will require reconsideration of the appropriate
    Such plans should take into account not only        degree of “constructive clarity” regarding central
the time frame for reducing budget deficits but          bank roles in markets—a critical aspect of
also the need to deal with looming pension and          systemic stability—while also conserving an
health care problems. Failure to present credible       appropriate degree of “constructive ambiguity”
withdrawal strategies in a timely and convincing        concerning lender-of-last-resort measures for
manner could add to the currently rising volatility     individual firms that fall into difficulties (see
of interest rates and government bond yields,           Market Best Practices Report, pp. 58–62).
hurting the chances of global economic recovery.
    Public-sector withdrawal strategies need to          Recommendation 4: Clear strategies
include consideration by the central banks of the        should be developed for the withdrawal
transition back from the exceptional facilities put      of governments from ownership positions
in place during the crisis to support markets and        in financial institutions and for ending
to provide liquidity support to money markets.           extraordinary liquidity and market support
This will require defining a “new normal” state of        measures. Such strategies should be carefully
central bank liquidity facilities that will certainly    coordinated internationally to be fully effective
not be identical to the exceptional facilities of the    and minimize the risk of unanticipated
past year. The new normal will also most likely          consequences.
not be identical to the status quo ante 2007 and,




                                                             Institute of International Finance • July 2009   ■   23
    SECTION 2

A Shared Responsibility to Achieve Resilience




T
        he G-20’s Working Group 1 said that the        evaluate internal policies, processes, and proce-
        objective of regulatory reform is to build a   dures against the recommendations of the Report.
        financial system that will support growth       The IIF also has organized knowledge-sharing
and rising living standards across the globe while     meetings among member firms to allow them to
reducing the risk of financial instability. 7 It        share their experiences of self-assessment.
notes that financial crises have very large social          Member firms in major markets have
costs. At the same time there are large social ben-    reported that they have concluded gap analysis
efits to all from a dynamic and efficient financial       against the IIF Recommendations and parallel
system that transforms savings into productive         recommendations (for banks) of the Senior
investments and helps households and businesses        Supervisors Group and other groups. This
manage risks.                                          analysis has indicated in general a good deal
     Building and maintaining a high degree of         of progress regarding implementation of the
resilience in financial markets, while ensuring         Recommendations. Firms are in the process of
that excessive caution does not overwhelm              remedying identified shortcomings, most of
efficiency and innovation, stifling future growth,       which will be addressed by the end of 2009.
depends on the effective interaction of markets
and regulation and on the quality and success          2.1. RISK MANAGEMENT—
of the relationship between authorities and                 A SECULAR CHANGE IN
firms. Achieving financial stability is a shared
                                                            PROGRESS
responsibility.
     The IIF’s Market Best Practices Report was        Significant progress is being made by firms to
published in July 2008. It detailed the wide           address the weaknesses identified in the Market
range of weaknesses and vulnerabilities in firms’       Best Practices Report and by regulators.
business practices that contributed to the devel-          Work on risk management goes beyond
opment of the crisis. It set out a large number of     simple improvements. Rather, a step change
recommendations for change.                            in firms’ approaches to risk management is
     Since then, there has been an active dialogue     starting to be evident. This is essential as strong
among IIF members to assess implementation             risk management is the first line of defense in
of recommendations of the Report. To facilitate        ensuring the soundness of firms. Reforms include
the process, the IIF has made available a model        the following:
methodology for self-assessment, which provides
a framework through which members can                       Improvement in the governance of risk
                                                            management, with revised responsibilities
7G-20 Working Group 1: Enhancing sound regulation           and oversight functions of senior manage-
and strengthening transparency, March 25, 2009.             ments and boards;

                                                            Institute of International Finance • July 2009   ■   25
     At some firms, an overhaul and compre-             stock of implementation and formulating an
     hensive revamping of the risk systems and         updated view of the issues raised in the Market
     infrastructure, including personnel decisions     Best Practices Report. This upcoming report will
     aimed at bringing in top talent to guide these    summarize the state of the industry, highlighting
     efforts;                                          changes and improvements in the industry’s
     Making more robust the process of defining         landscape since the release of the Market Best
     and enforcing the firm’s risk appetite;            Practices Report in July 2008 and identifying
     Especially in highly affected firms,               open issues that still need to be addressed by
     consciously addressing deficiencies of risk        the industry or regulators. It also will provide
     culture;                                          additional recommendations on a number of
     Revision and improvement of internal              matters related to risk management.
     risk models, with particular emphasis on
     Value at Risk (VaR) and understanding and          Commitment II: The IIF membership will as a
     managing its limitations to assess risk during     matter of first-order priority continue the good
     times of economic stress;                          progress to bring their risk management and
     Investment in risk-related information             other business practices into alignment with the
     technology, including quicker and more             recommendations of the Market Best Practices
     reliable aggregation capabilities;                 Report.
     Significant improvement in stress-testing
                                                        Commitment III: The standards set out
     techniques and capabilities, including
                                                        in the Market Best Practices Report have
     approaches to develop firm-wide views on
                                                        become a benchmark for large, internationally
     the impact of adverse economic scenarios;
                                                        active firms. The industry welcomes the use
     Enhanced liquidity management, including
                                                        of this and other reports, such as the Senior
     adequate internal pricing of liquidity to
                                                        Supervisors Group Report of March 6, 2008,
     avoid “free lunch” use of liquidity, as well as
                                                        in the supervisory assessment of the quality of
     increased liquidity buffers;
                                                        risk management of such firms.
     Increased capital in many firms (in response
     to market and official demand);
     Substantially improved valuation, especially
     of less-liquid assets, assisted by method-        Compensation
     ological improvements and improved
                                                       Early in the crisis, industry bodies recognized
     external pricing infrastructure;
                                                       that mismanaged compensation incentives were
     Enhanced accounting, in line with evolving
                                                       a factor in the build-up of risk within firms,
     guidance by the standard-setters; and
                                                       thereby contributing to market instability. The
     Greatly enhanced transparency in securi-
                                                       IIF’s 2008 Market Best Practices Report set out
     tization businesses, thanks in large part to
                                                       seven Principles of Conduct to guide the industry
     industry initiative as well as enhanced
                                                       in its restructuring of compensation practices. By
     Pillar 3 transparency on risk management.
                                                       way of follow-up, the IIF conducted an industry
                                                       survey of the status of compensation reform
    In addition, the IIF is developing a report
                                                       earlier this year. The survey results, published in
(to be issued in late November 2009) taking
                                                       collaboration with the management consultants




26   ■   Restoring Confidence, Creating Resilience
Oliver Wyman in March 2009,8 were widely
disseminated and shared with key regulators.               Commitment IV: The industry is committed
    The survey showed that while much progress             to continue to implement reforms in
has been achieved, further work remained to be             compensation practices so as to align
done, including on the adjustment of perfor-               these practices with the IIF Principles and
mance compensation to the time horizon of risk             recommended leading practices, as well as
and the cost of capital and on the governance of           with the FSB Principles. In this regard,
compensation within firms. The survey results               the IIF intends to monitor developments in
also helped crystallize a set of recommended               industry practices and to provide an informal
leading practices which further amplify and                assessment in the forthcoming report of the
enhance the seven Principles of Conduct of the             IIF Steering Committee on Implementation
earlier report.                                            in November 2009 and to conduct a survey of
    Since early this year, the FSB has issued              industry practices in 2010.
Principles for Sound Compensation Practices9
                                                           Recommendation 5: Regulatory authorities
while several national authorities have also issued
                                                           should develop appropriate supervisory
guidelines providing a broad framework for
                                                           guidelines on compensation, in line with the
the governance of compensation policies and
                                                           FSB Principles, in a timely manner so as to
approaches to their supervision. The financial
                                                           reduce market uncertainty. The FSB should
services industry has generally welcomed the
                                                           ensure that these guidelines are consistent,
principles-based approach set out in the official
                                                           in all important respects, across jurisdictions
statements, which are broadly consistent with
                                                           and that a reformed regulatory environment
the IIF principles and recommended leading
                                                           also provides for a level playing field on
practices.
                                                           compensation between the regulated and
    The industry is determined to proceed with
                                                           non-regulated segments of the financial
ongoing reforms in this critical area to ensure that
                                                           market.
industry practices are aligned with the core IIF
principles and leading practices as well as with
FSB principles.
                                                          Securitization
8 Compensation in Financial Services: Industry Progress   One frequently cited cause of the crisis was the
and the Agenda for Change, March 30, 2009, http://        precipitous decline in value of many complex
www.iif.com/press/press+101.php.                          securitizations. At the same time, securitization
9 April 2, 2009.
                                                          as a broad asset category served major markets
                                                          extremely well for many years prior to mid-2007.
                                                          Securitization of credit card receivables, student
                                                          loans, automobile loans, and “vanilla” or standard
                                                          mortgages was an essential source of credit for the
                                                          real economy. To achieve a robust recovery, such
                                                          securitization needs to return to a significant role
                                                          in credit generation.
                                                              As discussed further in Sub-section 3.1 and
                                                          Section 5, where structures are not complex,
                                                          assets are well understood, underlying lending
                                                          standards are maintained, and adequate trans-


                                                               Institute of International Finance • July 2009   ■   27
parency of the underlying assets exists, vanilla      and supervision work successfully as it is on the
securitizations have been relatively resilient even   official sector.
in difficult markets.
    Bank balance sheets will certainly not be         High-Quality, Critical Analysis and Receptive
able to replace credit securitization as it has       Engagement by Firms
been provided in recent decades. Rather, simpler
                                                      Strong and effective supervisory engagement
structures based on good underwriting standards,
                                                      between firms and supervisors depends on a
well-understood assets, and ongoing transparency
                                                      mutual commitment to a dynamic, high-quality
are the answer.
                                                      dialogue of critique and challenge.
    There are several dimensions to achieving
                                                          This commitment requires that the industry
this. These include uniform, high standards of
                                                      engage positively and non-defensively with
underwriting; better analysis by institutional
                                                      supervisors. This is by no means an easy
investors; and ratings reform, as discussed in
                                                      challenge, as profit and loss are at stake. Success
Section D.V of the Market Best Practices Report.
                                                      depends on the creation of appropriate incen-
    These issues are being addressed by firms in
                                                      tives for personnel and the creation of a strongly
the market, by the rating agencies, and by the
                                                      supportive culture within the firm.
regulators, especially with respect to standards
                                                          The more-intense supervisory engagement
applicable to origination of the underlying
                                                      advocated by many as a lesson learned of the
lending, in particular mortgages.
                                                      crisis clearly requires a large number of highly
    Nothing is more essential than providing
                                                      qualified supervisors, appropriately resourced
ongoing transparency as to the assets underlying
                                                      to develop strong analysis, and with levels of
securitizations and, as mentioned in more detail
                                                      seniority and authority to engage firms in a
in Section 5, the product specialist associations
                                                      strong, critical, and analytical dialogue.
in the securitization sphere have made very
significant strides to improve availability to the
                                                      An Improved Culture
market of information on underlying assets and
overall documentation.                                The cultural response to supervisory intervention
    Taken together, all these changes, when           differs across firms. In some, it is mature and
complete, will provide a solid basis for the          healthy. In others, it is less so.
return of widespread use of the kinds of simple,           It is necessary that firms take engagement
transparent securitizations that will ensure a        with supervisors not as a necessary evil but as
renewed flow of credit to important consumer           essential to normal management. Engaging
sectors while avoiding recent excesses, subject to    constructively with supervisors can be a valuable
regulatory and accounting changes as discussed in     process for continual improvement of products
Section 3.                                            and returns to shareholders, as well as a means to
                                                      reduce financial, legal, and reputation risk.
2.2. EFFECTIVE SUPERVISION IS A                            Work being carried out by the IIF suggests
     TWO-WAY PROCESS                                  not only that specific cultural traits are critical to
                                                      healthy risk management within a firm but also
Successful regulation and supervision, like           that it is possible to implement specific measures
successful policing, is highly dependent on           to foster a positive risk culture within a relatively
the attitude and approach of the community            short period of time. This is an area of important
being regulated and supervised. It is as much         continuing work. The IIF will publish the results
incumbent on the industry to make regulation          of its work in this area in the November report
                                                      mentioned above.

28   ■   Restoring Confidence, Creating Resilience
    Many firms have been actively addressing                 Putting the focus on management judgment,
internal cultural issues uncovered by the crisis,       as opposed to reliance on a few numbers from
and all firms should take the steps necessary to         risk management systems or ticking regulatory
create a sound risk culture in accordance with          boxes, puts more, not less, pressure on manage-
the recommendations of the 2008 Market Best             ment to act prudently in accordance with the
Practices Report.                                       firm’s articulated risk appetite. It also puts more
                                                        pressure on supervisors to evaluate the substance
Setting Clear Principles and Holding                    and quality of a firm’s risk management as
Firms to Them                                           opposed to formal compliance.
                                                            Among the fundamental lessons of the
The IIF has long been supportive of outcomes-
                                                        crisis are that risk systems are of little avail if
focused regulatory approaches that rely to a
                                                        not used critically and with good judgment by
large but well-considered extent on principles, as
                                                        management and that supervisory challenges must
opposed to over-reliance on detailed rules. As was
                                                        go beyond looking at numbers and checking that
said in the 2006 Proposal for a Strategic Dialogue
                                                        rules are not transgressed. As the 2006 Proposal
on Effective Regulation,10 “at a general level, the
                                                        acknowledged, principles-based regulation is
IIF is supportive of ‘principles-based’ regulation,
                                                        in fact harder for all concerned, but the crisis
but is realistic about what this entails. Principles-
                                                        demonstrates that good judgment measured
based regulation requires more dialogue, greater
                                                        against actual outcomes is the bottom line of
willingness by regulators to make and stand
                                                        success for both management and supervisors.
by judgments of what constitutes acceptable
compliance, and readiness by firms to accept
                                                        Providing Risk-Based Supervision
those judgments.”
     There will always be a need for a material         Risk-based approaches to supervision will be
rules-based component of financial regulation.           essential to achieving desired objectives for the
However, this should never be allowed to give rise      future. While important before, these approaches
to a tick-box mentality in which formal adherence       become of even greater significance in light of the
to rules outweighs thoughtful compliance with           recognized need for an enhanced supervisory role
sound principles. All participants—in firms              in respect of risk to financial stability.
and authorities—should act on a strong under-               The industry accepts that to the extent that
standing of relevant activities and products and        risks are greater, the intensity of supervision
of their risks, using good judgment on the basis of     should increase. It sounds a note of caution,
and constrained by rigorous principles.                 however, for all to be watchful for the potential
     What is needed, accordingly, is an approach        for unintended consequences if the new require-
that strives for a good balance and well-               ments cause risks to migrate to less-regulated
considered interaction between principles and           parts of the system, where they are more difficult
rules. This balance should seek to maximize             to identify and manage.
resilience by prioritizing the use of analytical
judgment across the system and to optimize              Aligning Incentives
the alignment of incentives toward efficiently
                                                        The correction of procyclical tendencies in the
prudent industry behavior and clearly understood
                                                        current Pillar 1 of Basel II mandated by the G-20
regulatory outcomes.
                                                        and discussed further below at Sub-section 3.2
10
                                                        will come at a cost. A full analysis of the actual
  Proposal for a Strategic Dialogue on Effective
                                                        extent of the procyclicality of the Accord is still
Regulation, December 13, 2006, http://www.iif.com/
regulatory/effreg.                                      needed, but it is possible that the new regime

                                                             Institute of International Finance • July 2009   ■   29
may be less sensitive to risk. As we have seen in      analysis into effective oversight and micropru-
the past, non-risk-sensitive capital requirements      dential action creates significant new challenges
can pose or amplify systemic risks. Perverse           for supervision. As an international consensus
incentives set by non-risk-sensitive capital           on the scope, goals, and modalities of macro-
requirements under Basel I have been among the         prudential scrutiny of market and economic
root causes of this crisis, and there is the danger    developments still needs to be developed, so too
of similar problems’ emerging depending on             do the means of implementation. International
how cyclicality is addressed and if overly rigid       consistency on the goals and means of implemen-
measures are introduced on leverage (discussed         tation of the new mandate for macroprudential
in Sub-section 3.4).                                   oversight will be essential to avoid competitive
    Appropriate incentives will need to be             and even economic distortions. A sophisticated,
provided through Pillar 2 enforcement tools.           risk-based, outcomes-focused approach to
Capital add-ons are the primary tool for setting       incorporating macroprudential inputs into
incentives under Pillar 2 and should be subject        microprudential supervision based on continuous
to a balanced system of surcharges and discounts       improvement of internal risk management will be
reflecting the full range of findings from super-        a necessity.
visory scrutiny. In addition, there are further            More sophisticated microprudential super-
options for tangible reward and penalty reflecting      vision will need to be complemented by effective
an institution’s record under the Pillar 2 review      feedback from the microprudential level to
and evaluation:                                        macroprudential oversight. The macroprudential
      Well in line with the logic of a risk-based      process will be most effective if it uses bottom-up
      approach to microprudential supervision, an      insights from supervisors and colleges as well as
      institution’s Pillar 2 record should drive the   top-down macroeconomic analysis. To achieve
      frequency and intensity of the supervisory       this, a new dimension of horizontal, thematic
      review and evaluation process.                   work across peer groups of institutions and across
      An institution’s Pillar 2 record also should     jurisdictions will be necessary.
      inform the size of qualitative adjustments           The microprudential implementation of
      applied under the advanced measurement           macroprudential oversight and analysis will
      approach to operational risk.                    make the demands on supervisors all the more
      Increasing microprudential supervision           challenging. The proper calibration of capital
      will be costly, and a significant escalation      add-ons, supervisory directions regarding the
      in supervisory fees assigned to the industry     countercyclical draw-down or build-up of
      can be expected in the relevant jurisdictions.   additional risk buffers, and supervisory measures
      Here as well, risk- and incentives-based         to remedy identified deficiencies of broader
      criteria should and can be easily combined       market practices will require robust risk analysis
      to develop a fee allocation formula that         and difficult judgment calls when translating the
      rewards or penalizes as appropriate an           analysis into supervisory action.
      institution’s behavior.                              The implications are obvious. In addition to
                                                       the general need for enhanced capability, micro-
Microprudential Implementation of                      prudential supervision will require significantly
Macroprudential Oversight and Analysis                 more resources, broader expertise, and a wider
                                                       set of skills. In order to help identify systemic
As discussed in Sub-section 4.4, a very important
                                                       vulnerabilities and cyclical risks they will have to
aspect of the new framework will be the focus on
                                                       develop a deeper understanding of institutions’
systemic risk. The translation of macroprudential


30   ■   Restoring Confidence, Creating Resilience
businesses and business models, of their risk                 A “market-failure” based approach to
measurement and management practices, of                  regulation is sensible and by now well grounded
their governance, and of the national and global          in extensive academic and supervisory literature.
markets in which they are operating.                      Regulation usually is justified where necessary to
                                                          achieve better outcomes than could be achieved
     Commitment V: The IIF membership will                by participants left to themselves.
     undertake the efforts and investment necessary           Market-failure analysis should remain the
     to promote the success of more outcomes-             basic justifying premise for financial regulation.
     focused, judgment-based supervision. This            At the same time, we do not believe that the use
     will include developing standards and norms          of market-failure analysis should become unduly
     of behavior to underpin a better quality of          narrow or trapped in the application of overly
     relationship with supervisors.                       rigid econometric techniques designed to prove
                                                          or quantify market failure. Such techniques can
     Recommendation 6: Authorities should
                                                          be useful as a point of reference but should not
     continue to develop a more consistently
                                                          detract from the need to make sound, whole-
     outcomes-focused, judgment-based approach to
                                                          picture judgments as to whether or not markets
     regulation. The IIF recommends increasing the
                                                          need assistance in delivering desired outcomes.
     resources, expertise, and skills of supervisors to
     implement macroprudential oversight.
                                                          Understanding Impacts, Weighing Benefits
                                                          Any debate as to the need for specific regula-
                                                          tions needs a robust understanding of the likely
2.3. MAKING REGULATION                                    impact in terms of incentives, costs, and expected
     EFFECTIVE                                            benefits. This has been a long-standing view of
A Robust Approach to Developing Financial                 the IIF12 and remains equally valid today.
Regulation                                                    However, it does not always add to the quality
                                                          of the discussion to try to put precise monetary
There has been growing agreement between                  values on the impacts or potential implications
policymakers and industry participants on the             of different regulatory proposals. Trying to attach
merits of an integrated approach to developing            monetary values to impacts that often are diffuse
effective regulation.11 The process consists              and long-term, so as to make them meaningfully
broadly of the following:                                 weighable against the putative benefits, can in
   1. Problem identification and market-                   certain circumstances undermine the importance
       failure analysis;                                  of high-quality impact analysis. As we said in our
   2. Definition of objectives;                            2006 Proposal, “costs and benefits are often hard
   3. Development of policy options and impact            to quantify, and impacts should not be assessed
       assessment;                                        solely or even primarily on the basis of narrow
   4. Consultation with stakeholders;                     efforts at quantification.”
   5. Policy decision; and                                    High-quality impact analysis, taking into
   6. Review once the policy has been                     account the effects of proposals on the overall
       implemented and enforced.                          efficiency of the system as well as effects on
                                                          individual firms, remains essential to achieving
                                                          effective and efficient regulation. It is of the
11See, for example, European Commission, Impact
Assessment Guidelines, January 2009; CESR–CEBS–           12See A Proposal for a Strategic Dialogue on Effective
CEIOPS, Impact Assessment Guidelines, April 2008.         Regulation.


                                                               Institute of International Finance • July 2009   ■   31
utmost importance that the potential impact
be assessed rigorously and having regard to the         Recommendation 7: It is essential that
best data and information that is reasonably            regulation be effective while ensuring that
practicably achievable. These impacts then are          markets remain as efficient as possible. The
effectively weighed against the benefits likely to be    principles of effective regulation should be
achieved.                                               followed, including:
                                                            Clearly identified objectives;
Incentives-Directed Regulation                              Clear understanding of impacts, both
It is important that regulation be based as much            positive and negative (but avoiding
as possible on engagement with market incen-                mechanistic or purely quantitative
tives. To lever the incentives of firm management            methods);
is likely to be both more effective and more                An incentives-focused methodology; and
efficient than simply to impose requirements.                Incorporation of consultation and dialogue.
     To give an example, an approach that rewards
strong and effective risk management within a
firm is likely to produce much better results in        Dialogue on Effective Regulation
the long run than an approach that prescribes
separate sets of requirements that become a pure       One aim of the IIF’s 2006 Proposal on effective
compliance exercise divorced from the way the          regulation was “to establish an ongoing, strategic
firm is run.                                            dialogue between the two groups, focused on a
                                                       clearer appreciation of common goals, effective
Appropriate Differentiation                            and efficient regulatory approaches, and methods
                                                       by which these objectives can best be achieved.”
Reflecting a risk-based approach, the revised               In view of recent events and of the scale of the
regulatory framework should be appropriately           challenge that lies ahead, there would be consid-
differentiated. Similar activities, such as banking    erable merit in taking this proposal forward at
and insurance, can share similar risks and, at the     this stage. The FSB recently has been expanded
same time, exhibit real differences that should be     and provided with a considerably enhanced
reflected in the regulatory approach.                   mandate. It has announced the establishment
    For example, insurers are primarily funded by      of a Standing Committee for Supervisory and
advance premium payments, which in most cases          Regulatory Cooperation.
cannot be withdrawn on demand or prematurely               The next step is to establish a mechanism for
(exceptions are certain life insurance policies).      structured dialogue between the FSB and industry
This means that the different liquidity profile         representatives to focus on the achievement of
of insurance business should be recognized.            effective regulation during the period immedi-
Similarly, recognition must be given to the            ately ahead, when resolution of the crisis will
different nature of insurance risks, which tend        create the opportunities to improve the regulatory
not to be correlated with market risk.                 architecture substantially. The FSB is uniquely
                                                       placed to ensure that the dialogue transcends
                                                       the traditional sectoral boundaries within the
                                                       financial services industry—banking, securities,
                                                       and insurance—and the traditional allocations
                                                       of responsibilities between prudential conduct of
                                                       business and market regulators, while also taking
                                                       on board the new macroprudential perspectives.

32   ■   Restoring Confidence, Creating Resilience
                                                       ishing risk taking, but only at significant cost to
 Recommendation 8: There should be a                   credit availability and economic performance.
 structured, ongoing dialogue between the                  To achieve meaningful market discipline, it
 FSB, the standard-setters, and the industry           is important that creditors other than protected
 to support high-quality, effective, and well-         depositors or policyholders be at real risk of
 coordinated international regulatory reform.          loss in the event of the failure of a firm. Absent
 This should cover all financial sectors and all        perceived risk of loss, risks will be taken on the
 types of regulation (prudential and conduct of        assumption that ultimately the taxpayers will bear
 business).                                            such loss.

                                                       Two Complementary Paths
2.4. RELYING ON MARKETS TO                             The belief that firms were too big or too intercon-
     ACHIEVE STABILITY                                 nected to be allowed to fail with loss to creditors
                                                       appears to have been prevalent during the recent
A central question in the development of the new       period. Accordingly, the level of discipline was
international regulatory framework is the extent       reduced.
to which—in light of the events of the past two            Two complementary types of effort are
years—markets can be relied on generally to tend       needed.
toward financial stability. To the extent that this         On the one hand, as discussed above, it is
is not the case, regulation is more necessary to       necessary that regulation and supervision be
protect the system against damage.                     enhanced to ensure these risks are better under-
     The case for significantly reduced reliance on     stood by the community as a whole and better
markets is made succinctly in the Turner Review,       addressed at both microprudential and macro-
one of several voices calling into question the        prudential levels.
“efficient market” theories of the past 30 years.           On the other hand, there should be strong
It contends that there are increasingly effective      incentives so that investors—in particular,
criticisms that markets cannot be relied on, that      creditors with limited share in the upside of
the rationality of individual actors’ pursuing their   the risk taking—take action to reward prudent
own goals does not ensure collective rationality,      behavior and penalize undue risk taking. Market
and that individual behavior is in any event not       discipline failed in many cases to operate
entirely rational.                                     effectively in the period leading up to the
     It has long been recognized that markets          crisis. Accordingly, in addition to developing a
have important failings. One key failure is that       framework of enhanced regulation, an essential
participants can be expected to manage their risks     focus of effort should be to ensure that market
effectively up to the point where the cost of doing    discipline operates much more effectively for the
so makes sense from their own point of view.           future.
To the extent that costs are necessary to protect
others, markets do not reward or incentivize firms      Financial Firm Failure and Resolution
to do so.                                              Frameworks
     Equally, regulation has its limits. As Gary
Stern, President of the Federal Reserve Bank of        To increase the perceived chance that a significant
Minneapolis, has noted, an approach that relies        firm will be able to exit the market in an
unduly on regulation at the expense of market          orderly manner, significant enhancement of
discipline could conceivably succeed in dimin-         international regimes for dealing with failing
                                                       institutions should be a top priority. Means need

                                                            Institute of International Finance • July 2009   ■   33
to be developed for early intervention in, and         pants generally to achieve high levels of trans-
the orderly winding-up of, such institutions in        parency to support an effective market discipline
such a manner as not to cause undue damage             regime.
to the overall system while allowing losses to be
borne by creditors in line with applicable rules       Other Means to Increase Market Discipline
concerning priorities in insolvency proceedings.
                                                       There may be other means available to increase
This issue is discussed at length in Section 7.
                                                       overall levels of market discipline in the system.
The changes outlined there are essential to the
                                                       As part of the reform process, the industry
operation of strong market discipline for the
                                                       as well as the official sector should give close
future and thus to the success of the revised
                                                       consideration to all possible ways of increasing
regulatory framework.
                                                       the effectiveness of market discipline. The greater
    Making it possible for a major firm to exit
                                                       the extent to which this can be achieved, the
the market without causing severe disruption to
                                                       sounder and more efficient will be the system, the
the entire system also will require considerable
                                                       less intrusive the necessary regulation, and the
further attention to how to ameliorate the risks
                                                       lower the ultimate risk to fiscal authorities and
arising from the high degree of interconnect-
                                                       taxpayers.
edness of firms in the financial system without
                                                            In addition, the orderly withdrawal of
diminishing the substantial benefits that intercon-
                                                       extraordinary state support of firms and markets
nectedness produces. We consider these issues in
                                                       discussed in Sub-section 1.7 should be conducted
more detail in Section 5.
                                                       with the reinvigoration of market discipline as
                                                       one of its principal goals.
Transparency
Another reason why market discipline failed to          Recommendation 9: Resilience depends in
operate was that there was insufficient trans-           large part on the risk management of firms and
parency of critical products and activities, for        the functioning of markets. Regulation cannot
example, in respect to the underlying assets of         do the job on its own. It is essential to restore
structured products and their riskiness and to          and enhance market discipline, in particular by
the risk profiles of counterparties. The industry        ensuring that creditors of financial institutions
fully agrees that levels of meaningful transparency     (other than depositors and insurance policy-
need to be significantly increased.13 This issue         holders, and subject to the rules of priority in
is discussed in more detail in Section 5. Much          insolvency) are at risk of appropriate loss in
has already been done, and more is under way.           the event of failure. Reform should lever and
However, it will be necessary to review further         seek to enhance the positive dynamic between
whether this achieves everything that is necessary      markets operating under effective discipline
to ensure effective market discipline.                  and more effective regulation.
     The industry is committed to continue to
work with the official sector and market partici-
13   See Market Best Practices Report, Section D.VI.




34      ■   Restoring Confidence, Creating Resilience
 SECTION 3

Achieving Resilience Through the Cycle With
Prudential and Accounting Standards




I
     n this section, we provide an industry view      of the insurance business also need to be weighed
     on what is required to enhance the role          carefully, and hasty conclusions should be
     capital and liquidity requirements and ac-       avoided.
counting standards play in absorbing market and
systemic shocks. Experience shows that current        Need for Enhancement
requirements need to be better adapted to times
                                                      It is widely agreed that levels of capital in many
of stress or economic downturn. In particular,
                                                      parts of the system leading up to the crisis were
measures need to be taken to reduce procyclical-
                                                      insufficient, and a risk-based increase in such
ity. The overall outcome should be to ensure that
                                                      capital is necessary. The analysis must focus on
protection is available when most needed.
                                                      how to determine reasonable levels of capital that
                                                      serve the purposes of ongoing resilience of the
3.1. REGULATORY CAPITAL ISSUES                        system against future shocks but also underpin
Capital adequacy is a central issue being             sustainable credit provision.
considered as the industry and the regulatory              Quantity is, of course, not the only dimension
community ponder fundamental changes in the           to be considered. The quality of capital (avail-
global financial regulatory framework. Assuring        ability and loss absorption capacity), the adequate
adequate capital requirements and the necessary       control of leverage, and the management of
shock absorption capacity without stifling credit      cyclical volatility of capital all must be addressed
generation is a tremendous challenge and requires     in order to achieve a comprehensive framework
an informed debate about the level of stress          for financial institutions’ capital.
capital should insure against. In achieving the            Enhanced capital regulation must be globally
right balance it is fundamental to get the capital    consistent to ensure a level playing field and
foundation right. At the same time, it is necessary   avoid competitive distortions. This is certainly
to keep in mind that capital is not a panacea for     recognized in the Basel Committee’s agenda and
all problems; liquidity buffers, good management,     several of the regulatory proposals recently issued
rigorous risk management, robust corporate            including the Turner Review and the recent U.S.
governance, and strengthened supervision all          Treasury proposals.
have important roles to play.
     This discussion follows most of the debate in    Clear Objectives
the wake of the crisis in focusing on capital for     The consensus as to the need to reform overall
banks and investment firms. It should be kept          capital in the system has so far left unanswered
in mind that, while crisis issues need to be taken    the questions of how to achieve an appropriate
into account in making policy decisions as to         increase, the allocation of any increase across
parallel insurance requirements, the specificities


                                                           Institute of International Finance • July 2009   ■   35
risks and businesses and, indeed, the actual            risk management practices through additional
goals intended to be reached, beyond a general          Pillar 2 guidance (addressing fundamental issues
desire for greater stability. Clarity as to goals at    such as adequate stress testing, management
a somewhat more precise level is important. A           of risk concentrations, and firm-wide risk
“zero failure” objective would be ultimately highly     management) will reinforce on a consistent basis
damaging and must be resisted. Getting the levels       the work being done by firms to improve internal
right will not be easy. As has been made evident        risk management.
in the case of the trading book capital proposals,
a well-informed, technically alert back-and-forth       Requirements Should Reflect the Risk
between the public and private sectors on the           Profile of the Business
basis of careful impact studies is essential to get
                                                        The IIF has long advocated that regulatory
to a more stable but balanced and coherent set of
                                                        requirements should, in order to achieve robust
requirements.
                                                        outcomes and to avoid competitive distortions,
                                                        reflect the risk profiles of different business lines.
Basel II Remains the Correct Basis
                                                        This should be reflected in, for example, recog-
Even though public capital injections have been         nition of the different risk features of different
necessary in several cases, the industry has raised     business activities such as banking, insurance,
large amounts of capital from private sources           asset management, or investment advice. As
despite adverse conditions. Revisions to portfolio      stated, the important issue is not the legal nature
composition and asset divestitures are already          of the entity but rather the risk profile of the
resulting in reduced risk and greater capital           activities carried on.
adequacy.
    The IIF shares the G-20 view that, with             The Need for an Integrated Perspective
necessary adjustments, Basel II remains by far the      and Aggregate Assessment
best framework for setting the regulatory capital
                                                        This work needs to be conducted within an
requirements of financial institutions and that all
                                                        integrated perspective. It is clear that the combi-
jurisdictions, including the United States, should
                                                        nation of current capital requirements under
move expeditiously to effective implementation
                                                        Basel II, the effects of the inclusion of downturn
of the new Accord. In addition to setting capital
                                                        default data and reduced ratings into banks’
requirements on a rigorous basis, Basel II will
                                                        internal ratings-based (IRB) models, and the
continue to increase resilience by inducing
                                                        capital resulting from the implementation of the
ongoing improvement in risk management.
                                                        various enhancements to Pillars 1 and 2 proposed
Industry participants agree that the first step is
                                                        by the Basel Committee will deliver significantly
the Basel Committee’s current revision of the
                                                        greater capital levels.
risk-capturing features of Basel II. This follows
                                                            New capital requirements for resecuritiza-
the conviction that unless risk is appropriately
                                                        tions and trading book assets will dramatically
captured, minimum regulatory capital ratios
                                                        increase Pillar 1 regulatory capital. Indeed, the
(whether 8% or above) will not be meaningful
                                                        original proposals would have substantially
nor serve their purpose.
                                                        overshot the significant increase of capital for the
    Recent changes by the Basel Committee
                                                        trading book that is agreed to be necessary by
aimed at improving the risk capture of Basel II
                                                        industry and regulators alike. Although the final
address the most pressing deficiencies evidenced
                                                        standards published in July 2009 appear to be an
by the crisis: the capital treatment of resecuritiza-
                                                        improvement, a careful impact assessment needs
tions, exposures to off-balance sheet vehicles, and
                                                        to be done, and the industry is still studying the
trading book capital needs. Equally, strengthening

36   ■   Restoring Confidence, Creating Resilience
revised standards. As with all aspects of Basel II,           getting a complex new system right. Given that
consistent implementation of the new trading                  immediate problems of the crisis have largely
book regime will be critical, all the more so                 been addressed, time should be allowed for
because of the international nature of the trading            meaningful impact assessments and analysis
markets. Thus, it is important that the pending               before finalizing new requirements.
Capital Requirements Directive amendments                         The timing of such an evaluation is critical.
in Europe be modified on the lines of the final                 While there is a need to act decisively, capital
Basel version and that the United States and other            deficiencies in most large firms are being
countries faithfully implement it promptly.                   addressed. The effects of all the changes that are
     Additional Pillar 2 amounts determined by                being proposed will require adequate time for
regulators, including the potential impact of new             analysis. The analysis should be free of artificial
stress tests, will likely add significantly to the             deadlines, and finalization of each change of the
overall impact. Similar effects will result from              prudential capital regime should be made subject
additional capital buffers and measures designed              to appraisal of the likely all-in effects of the
to lessen procyclicality on a basis as yet to be              coming changes.
determined, a potential leverage ratio constraint,                Although the final standards published in
and a new and perhaps more limited definition                  July 2009 correct in substantial part what could
of Tier 1 capital. Furthermore, requirements for              have been very serious unintended consequences
liquidity buffers need to be considered jointly               for correlation trading, and the industry is still
with capital requirements, given the effects                  studying the revised standards, it is clear that
they will have on cost structures and funding                 not all unintended consequences, including
strategies. All this needs to be evaluated on an              disruption of risk management of existing
aggregate, not on a proposal-by-proposal, basis.              positions and likely impacts on the market prices
The implementation of Pillar 2 was discussed                  of certain instruments, have been addressed.
further in Sub-section 2.2.                                   The industry looks forward to continuing to
     Despite the evident need of integrated                   work with the Basel Committee on the projected
assessment, there is not as yet an estimation                 further refinements as the Basel Committee’s
of the magnitude of the capital effects the                   impact analysis continues.
pending changes will produce. Therefore, there
is an urgent need for a thorough study of the                 Earnings Capacity
overall impact of the new regime by the Basel
                                                              While capital and other protective measures
Committee in close consultation with the
                                                              are of essential importance, earnings and the
industry. This analysis should be aimed at deter-
                                                              capability to generate revenue commensurate
mining the actual level of total and Tier 1 capital
                                                              with a reasonable return are the foundation of
resulting from the various enhancements and
                                                              firms’ viability. Solid, sustainable earnings and
additions to the Basel II framework, combined
                                                              the market confidence that go with them are
with the impact of liquidity and other changes.
                                                              essential to developing lending capability and
This is critical because of the danger of damaging
                                                              longer term resilience—and thus to financial
unintended consequences for the whole market
                                                              system stability. Indeed, earnings capacity has
from overshooting a reasonable and necessary
                                                              appropriately been examined in conjunction with
increase.14 Nothing is more important than
14The Quantitative Impact Study currently being conducted by the Basel Committee covers only the trading book
and market risk proposals (that is, excluding the impact of Pillar 1 requirements for securitizations in the banking
book and exposures to off-balance sheet vehicles, as well as the very comprehensive changes to Pillar 2 in the areas
of stress testing, firm-wide risk management, valuation, and so forth).

                                                                   Institute of International Finance • July 2009   ■   37
capital in crisis-related, official-sector stress tests   regulatory requirements that affect their invest-
of individual firms’ ability to weather possible          ments. A lengthy discussion of where capital is to
further downturns. On a more macro basis, the            come from as state investments are reduced is not
solidity and diversification of earnings across the       within the scope of this report. It is, however, vital
financial services industry is an important aspect        that this issue be given a higher profile in interna-
of its ability to contribute to recovery and then        tional public- and private-sector discussions.
sustained growth. Thus, balancing capital and
other safeguards with the capacity to generate           International Coordination and Good
earnings is absolutely necessary, although often         Timing Essential
overlooked in public discussions of capital and
                                                         Among the most fundamental needs felt by IIF
prudential issues.
                                                         members are for international policy coordi-
                                                         nation and adequate timing of the reforms.
Innovation
                                                         Changes in the capital regime should be
Over the past 50 years, market-driven innovation         consistent internationally and not create market
has made tremendous contributions to economic            distortions or make unlevel the playing field.
welfare. It can also, of course, be misused. Certain     Similarly, although the point is certainly recog-
recent innovations have compounded complexity            nized by the Basel Committee, it is important
and opacity, obscuring underlying risks, which           not to introduce new requirements that would
became grossly disproportionate to any benefits.          contribute to short-term procyclicality by dimin-
These problems have been recognized widely, and          ishing further the already reduced credit capacity
are being dealt with by several initiatives. The         of the system. Rather, introduction of new
IIF is committed to building upon the progress           requirements should be phased in once recovery
already made to achieve the levels of transparency       is well established.
and market discipline necessary to avoid such
dangers in the future. Innovation remains                Credit Capacity and Securitization
essential to future progress, and will proceed in
                                                         Until recently, securitization remained the main
a context of stronger risk management, good
                                                         source of credit outside of bank balance sheets.
governance, and effective supervision based on
                                                         However, the cumulative effects of the various
the lessons learned of the crisis. In carrying out
                                                         changes may end up seriously hobbling the
regulatory reform great care must be taken not to
                                                         system’s lending capacity.
define requirements so narrowly as to constrict or
                                                             While complex resecuritizations should be
cut off future innovation.
                                                         subject to significantly increased capital charges
                                                         (although the market for them seems unlikely
Strategic Considerations for Capital Raising
                                                         to return in any case), they should be clearly
Importantly, both the industry and supervisors           differentiated from the more vanilla or standard
will need to consider whether the framework is           types of securitization that have been essential
adequate to attract equity investors with medium-        to provision of credit for asset categories such as
to long-term investment views as a part of the           automobile finance, student loans, credit cards,
overall problem of improving the incentives              and the familiar types of mortgages, which have
to which the industry responds. The roles that           performed well for many years until the problems
hedge funds, sovereign wealth funds, insurance           originating with sub-prime mortgages spiraled
companies, and pension funds can play are                out of control.
crucial but will require reconsideration of various



38   ■   Restoring Confidence, Creating Resilience
     There remains a serious danger that the           be implemented. Without belaboring what has
accretion of proposals for securitization,             already been an extensive debate, there remain
including increased capital requirements,              doubts about whether the requirements will
accounting changes, rating agency changes, and         achieve their stated goals. Moreover, there
“skin-in-the-game” retention requirements,             is concern that their downsides of making
may make it difficult to securitize the necessary       securitization less attractive for certain firms,
volume of assets to sustain adequate lending           more costly in capital terms, and more complex
capacity.                                              to manage both as a business matter and for
     It is important not to force transactions         purposes of risk management, will outbalance any
on-balance sheet, either by accounting or              gains. Concerns about the quality of transactions
by regulatory requirements, beyond what is             that have prompted these proposals—which are
necessary to correct true excesses of the prior        quite legitimate looking only at the period prior
period. In getting the balance right, not only         to July 2007—are in fact well on the way to being
should the need to maintain the conditions under       addressed by other means.
which securitization can continue to be done                As important as taking the aggregate effects
be factored in, but also the fact that substantial     of changes into account is close international
improvements in disclosures of off-balance sheet       alignment of all such requirements, which will
positions via Pillar 3 have already been promul-       have a significant effect on how future transac-
gated (see Sub-section 5.4).                           tions are done.
     The support of securitization by some of               Substantial industry initiatives are under
the government intervention programs shows             way to upgrade the documentation and trans-
its importance. Yet it is not clear that the overall   parency of securitization, including the European
effects of pending changes on this vital and           Securitisation Forum’s RMBS Issuer Principles for
reliable means of finance are being evaluated           Transparency and Disclosure15 and the American
carefully, as new requirements are being               Securitization Forum’s Project RESTART.16 These
developed individually.                                initiatives should make it possible for securitized
     Finalization of a new regime for securitization   finance to resume its essential role without recre-
needs to take into account the interaction of all      ating the risks that now well-understood excesses
the various proposals under consideration. Some        raised. Transparency is discussed further in
issues are still being debated, such as the derecog-   Section 5 below. Moreover, extensive changes in
nition and consolidation rules of accounting, and      origination of underlying assets and in under-
the IIF is making its contributions to that            writing standards and practices are being made as
debate, as on the corresponding prudential             a result of regulatory requirements and industry
regulatory and disclosure requirements regarding       recommendations such as those in the Market
off-balance sheet exposures. Others, including         Best Practices Report.
some of the recent Basel risk-weight modifica-
tions for resecuritizations, are relatively uncon-
troversial, although the impact of treatment of
securitizations in the new trading book require-
ments is yet to be analyzed fully.                     15 December 2008, see http://www.european
     “Skin-in-the-game” retention requirements         securitisation.com.
have been debated at length and are still going        16 July 2008, see www.americansecuritization.com/

through the political process but appear likely to     restart.




                                                            Institute of International Finance • July 2009   ■   39
                                                         Furthermore, there is a need for thorough analysis
  Commitment VI: Levels of capital in many               and hard data in order to develop a confident
  parts of the system were insufficient. The IIF          understanding of the real nature and extent of
  agrees that overall levels need to be increased,       procyclicality in the regulatory capital framework.
  within the framework of the Basel II risk-based
  approach, as compared to pre-crisis levels. The        Buffers Must Be Able to Be Drawn
  IIF membership stands ready to work with the           in a Downturn
  regulatory community on objective analysis
                                                         It is important that any measure be objective,
  of the cumulative net impact of proposed
                                                         transparent, and free of unintended consequences
  regulatory changes.
                                                         (in particular, in how it could affect the way firms
  Recommendation 10: The cumulative                      manage risks internally). If there are to be capital
  impact of proposed enhancements of capital             buffers, or reserves, it is of fundamental impor-
  requirements and other regulatory and                  tance that they be truly available to be drawn
  accounting changes should be fully assessed            down in economic downturns. Without this
  prior to final decisions being made.                    the result would be wasteful overcapitalization
                                                         without real benefit. This requires not only a
  Recommendation 11: The timing of
                                                         regulatory commitment but also buy-in from
  introduction of new requirements should be
                                                         the rating agencies and the market. The Basel
  carefully considered to ensure that they do not
                                                         Committee needs to give a high priority to this
  hinder recovery.
                                                         aspect of the problem.

                                                         Clarity Is Essential as to Aims
3.2. ADDRESSING CAPITAL                                  Furthermore, debate is needed as to whether
     CYCLICALITY                                         buffers should be specifically countercyclical or
It is agreed that measures need to be taken to           aimed only at mitigating artificial procyclicality
reduce levels of cyclicality in regulatory capital       of the regulatory capital framework. While both
requirements. Firms also are considering this            objectives deserve consideration, explicit counter-
from an internal risk management perspective.            cyclical buffers present additional challenges. Not
For example, firms are adopting a longer                  only would such buffers be extremely complex
perspective on capital planning, even at the level       to use, but they also would require vesting
of the definition of risk parameters. A dialogue          extensive discretionary powers in regulators
on the basis of the official sector’s parallel work       and central bankers, which could subject
under the G-20 mandate will be necessary as that         them to unmanageable political pressures that
work becomes more fully available. The related           would compromise their independence and the
issue of cyclicality of loan loss provisioning is        achievement of their properly regulatory goals.
discussed further below in this section.
     Various ideas have been floated to address           Discretion Should Be Limited
procyclicality. The industry generally is                Given that cycles will vary somewhat by country,
supportive of the concept of measures to reduce          determination of where in the cycle a specific
the procyclicality of regulatory requirements,           jurisdiction is (and the related decision of
including consideration of time-variable capital         whether or not banks should be able to draw
buffers or reserving. But the devil is in the details,   from the buffer) is a central question. Alternative
and there is as yet no consensus on how to               approaches include discretionary mechanisms
achieve what is in fact a difficult technical goal.

40   ■   Restoring Confidence, Creating Resilience
(by individual firms, prudential regulators, or         3.3. DEFINITION OF CAPITAL
systemic regulators) and formulaic (non-
                                                       The definition of regulatory capital is an
discretionary) mechanisms. At this point, and
                                                       important variable as international standard-
subject to more detailed debate, the industry’s
                                                       setters consider the specific contours of a revised
view is that discretionary elements should be
                                                       regulatory capital framework. IIF members agree
reduced to a minimum in order to make the
                                                       that a review of the quality of regulatory capital
process objective, predictable, and transparent.
                                                       and its definition as interpreted in different
                                                       jurisdictions should be undertaken.
The Approach Should Be an Integrated One
Importantly, consideration also is needed as           Market Developments Must Not
to the relationship between potential future           Exclude Debate
international capital buffers or reserves and the
                                                       To some extent, market demand has already
capital buffer mandated by regulators in various
                                                       started to drive the process of revising what
jurisdictions as a result of crisis-driven “stress
                                                       should be the components of firms’ capital.
tests.” In particular, it is necessary to determine
                                                       However, it is imperative that a thorough analysis
the specific objective sought by each measure in
                                                       and debate take place before making policy
order to avoid potential overlapping and ineffi-
                                                       decisions on the regulatory definition of capital,
cient requirements.
                                                       as current market pressures may not be the right
                                                       guide for a long-term definition of capital.
Coordination Is Important
More broadly, international coordination on any        International Consistency Is Essential
decision to impose capital buffers or reserves
                                                       International consistency is essential. Any review
on top of other capital requirements is of vital
                                                       must be highly coordinated in order to achieve
importance. While the economic cycle can vary
                                                       convergence of interpretation and implemen-
across jurisdictions, it is important that objective
                                                       tation. A “common language,” avoiding major
criteria be established so that competitive distor-
                                                       interpretative divergences in the future, would
tions do not arise.
                                                       help avoid competitive disparities and ineffi-
                                                       ciencies in how regulators and markets deal with
  Commitment VII: The IIF supports measures
                                                       financial crises and bank insolvencies.
  to counter cyclicality by building resources in
                                                            The Basel Committee is undertaking an
  good times that can be drawn down in bad
                                                       analysis of the definition of capital. The industry
  times.
                                                       is committed to participating in this discussion
  Recommendation 12: Buffers, whether                  constructively, guided by the overall objective of
  created by capital or reserves, should be able       ensuring high-quality Tier 1 capital, including
  to be drawn on when needed without adverse           common equity, retained earnings, and robust
  consequence.                                         forms of preferred stock or instruments with
                                                       similar loss absorption capabilities, subject to
  Recommendation 13: There should be
                                                       internationally agreed deductions.
  dialogue between the official sector and the
  industry to develop effective approaches to the
                                                       Accounting and Tax Effects Should
  very difficult task of evaluating the cycle and
                                                       Be Considered
  deciding when to apply buffer mechanisms, on
  the upside or the downside.                          Some disparities across jurisdictions derive from
                                                       inconsistencies between International Financial

                                                            Institute of International Finance • July 2009   ■   41
Reporting Standards (IFRS) and Financial              way of banks’ using such instruments when
Accounting Standards Board (FASB) accounting          market conditions permit.
standards. Hence, accounting harmonization                Importantly, it seems premature to adopt
is part of the solution on issues related to the      any final decision on the distribution of capital
elements of capital. Similarly, tax inconsistencies   between Tiers 1 and 2. The original concept of
play an important role and must be resolved if        Pillar 1 is that it is a measure of risks in the bank
a truly harmonized, stable framework is to be         and careful study should be given before any
achieved. Inconsistent treatment of different         adjustment of the original ratios of Tier 1 and 2,
instruments for tax purposes within national          in terms of impact on the overall economy as well
regimes and further inconsistencies across            as on the prudential solvency of firms.
national regimes also have a major effect on
firms’ incentives as they approach their capital       Tier 3 Also Should Be Considered
strategies, their choices of instruments, and their
                                                      Debate also is required on the future of Tier 3
relationships with the markets.
                                                      capital, aimed at supporting short-term trading
    While the tax issue is complex, and problems
                                                      exposures. As with Tier 2 capital, there should not
of revenue neutrality of any change must be
                                                      be a rush to judgment, but rather the future role
recognized, it puts to the test governments’
                                                      of Tier 3 capital should be reevaluated once the
willingness to develop a truly international
                                                      whole picture on the regulatory capital treatment
regime on capital. The tax dimension is funda-
                                                      of the trading book is clear and firms’ adjusted
mental to any discussion of firms’ capital struc-
                                                      business models have settled down in the new
tures, and its discussion should not be avoided.
                                                      market that will emerge.
Tier 2 Remains Important
                                                      Impact Assessment Is Needed
The current quasi-exclusive focus on Tier 1
                                                      As with other changes that have an effect on the
capital is a further source of concern. While focus
                                                      cost of capital and the cost of sustaining credit
on Tier 1 is warranted, complete disregard of
                                                      businesses, any changes to the international
Tier 2 capital is not. As the system emerges
                                                      definition of capital should be undertaken only
from the crisis, it will be important to renew
                                                      once there is a confident assessment of the
recognition of instruments such as subordinated
                                                      cumulative impact of all other changes under
debt, which are effective as bank capital elements,
                                                      consideration.
particularly on a gone concern basis where
protection of depositors becomes the more
                                                        Commitment VIII: The IIF agrees that the
relevant. This will be all the more important if
                                                        quality of capital required needs to be reviewed.
a more robust international resolution regime
                                                        The IIF membership is ready to work closely
emerges, which will make having a full range of
                                                        with the official sector to achieve an outcome
instruments available important.
                                                        that reflects the lessons learned from the recent
     Moreover, it will be important to give careful
                                                        period.
consideration to the role of Tier 2 capital that
is convertible into Tier 1. Firms with buffers of       Recommendation 14: Consistent international
convertible Tier 2 instruments as part of their         requirements for the definition and quality of
contingency plans were well served by them.             capital, in particular Tier 1 capital, should be
There is, of course, a question of the market’s         developed. They should be applied consistently
assessment of such instruments from time                on a global basis. The benefits of Tier 2 capital,
to time; however, a sound regulatory capital            including convertible Tier 2, should not be
framework would not put impediments in the              underestimated.

42   ■   Restoring Confidence, Creating Resilience
3.4. CONTROLLING LEVERAGE                                  Take into account differences between
                                                           accounting standards17 (in particular,
There is agreement that excessive leverage
                                                           regarding on- and off-balance sheet items);
had developed in the system, and this must be
                                                           Take into account netting, hedges,
controlled in the future. Significant progress has
                                                           off-balance sheet items, and differences in
been made by the industry in reducing leverage as
                                                           business models as differences in funding
evidenced by various recent analyses. While this
                                                           structures;
trend continues, there also is appropriate concern
                                                           Allow flexibility so that its application does
about the speed of deleveraging and its effects on
                                                           not result in discriminatory treatment of
the real economy.
                                                           certain business models or certain jurisdic-
                                                           tions; and
Best Means of Control?
                                                           Be internationally agreed and consistently
Fundamentally, it is essential to have a debate on         applied across jurisdictions. The macro-
how to design leverage measures that will achieve          effects of any supplemental measures to
the goal of having a backstop to capital require-          control leverage must be examined carefully,
ments without putting a brake on well-managed              both on a domestic and on an international
risk-taking and without creating disincentives             level.
to business in low-risk assets. In so doing, it
should be kept in mind that the more robust               More fundamentally, supervisory tools
capital regime will also have a substantial effect    to contain leverage may be useful, but only if
on leverage in the regulated financial sector,         correctly applied. Experience during the crisis
which underscores that any additional measures        of banks operating under jurisdictions with a
against excessive leverage should be designed         leverage ratio demonstrates that its benefits are
as true backstops to correct anomalies or             not always evident, even if combined with other
outlier behaviors, not to supplant sound capital      regulatory tools. Consideration of leverage should
requirements.                                         clearly be part of each firm’s dialogue with its
    Moreover, if the goal is to prevent firms from     supervisor. Rather than operating as a hard,
gearing up to excessive leverage, supplemental        Pillar 1 type of mandatory requirement, a supple-
prudential measures are appropriate. However,         mental measure looking at leverage should be
it would not be appropriate to conflate leverage       used as one indicator among many, under a
control measures with the separate issue of           Pillar 2 approach.
whether in individual cases there should be limits        If well designed, this Pillar 2 approach can
on growth, scale, or diversification of the business   result in appropriately targeted supervisory inter-
conducted by a given firm (see Section 4).             vention, including increased monitoring, targeted
                                                      remedial requirements, or additional capital
Design Criteria                                       requirements. Under Pillar 2, specific measures
                                                      would be adopted only after supervisory dialogue
As part of the debate on establishing at the
                                                      has taken place, taking into account all the facts
international level supplemental tools to control
                                                      and circumstances, including such issues as
leverage, it is important to underscore some
                                                      the components of the assets included in the
basic design criteria. Any measure should do the
following:                                            17The industry is glad to see that the official sector
                                                      (including in particular the Basel Committee on
                                                      Banking Supervision and the European Commission)
                                                      has recognized this problem but reiterates that it is
                                                      fundamental.

                                                           Institute of International Finance • July 2009   ■   43
calculation (for example, government paper and       High-Level Dialogue
less-risky, standard mortgages), as well as the
                                                     In the Market Best Practices Report and
appropriate way to cover off-balance sheet assets
                                                     subsequent statements, the IIF has called for a
without resulting in exaggerated and dispro-
                                                     comprehensive, unbiased, high-level dialogue on
portionate effects. Rather than a mechanical
                                                     current accounting standards in light of the crisis,
tool, supplemental measures of leverage have
                                                     involving all relevant parties. Although consul-
great potential as determinants of enhanced
                                                     tative processes have been initiated, the need for
supervisory dialogue. By contrast, any simplistic,
                                                     a comprehensive and integrated high-level review
gross measure, applied across the board, is likely
                                                     of all aspects of accounting issues in light of
to reflect poorly firms’ actual short-term liquidity
                                                     experience in the crisis remains high.
situations, might induce firms to take on a riskier
mix of assets than would otherwise be the case,
                                                      Recommendation 16: There should be a
and can distort business incentives and encourage
                                                      comprehensive, high-level dialogue on current
arbitrage.
                                                      accounting standards in light of the crisis
    It goes without saying that the foregoing
                                                      and the changing regulatory environment.
discussion is focused on the widely discussed
                                                      This should involve all relevant parties while
issue of supplemental leverage measures for
                                                      respecting the independence of the standard-
banks. As the leverage issues facing insurance
                                                      setting process.
businesses are quite different, it should not be
taken to apply to them.

 Commitment IX: The IIF agrees leverage              Role of Accounting Standards
 was too high and needs to be appropriately          in Promoting Confidence
 controlled in the future.
                                                     There should be a thoughtful review of the role
 Recommendation 15: A simple leverage ratio          of accounting standards in international capital
 runs the risk of undermining its own objectives.    markets. Transparency, reliability, and represen-
 Any measure to contain leverage should take         tational faithfulness are objectives that should
 account of differences in business models           be the key drivers of any reform in the context
 and funding structures, major differences in        of reviewing the existing accounting regime. By
 risk profiles, distinct market practices and         the same token, such a review should, wherever
 characteristics, and differences in accounting      possible, include consideration of efforts to
 standards. Leverage should be addressed as a        contain financial instability.
 supervisory tool for use as part of the Pillar 2         The G-20 mandate “to reduce the complexity
 dialogue between a firm and its supervisor.          of accounting standards for financial instru-
                                                     ments and enhance presentation standards to
                                                     allow the users of financial statements to better
                                                     assess the uncertainty surrounding the valuation
3.5. ACCOUNTING                                      of financial instruments” is a step in the right
This section highlights considerations for the       direction. The IIF supports the accounting
official sector that remain compelling as discus-     standard-setters’ efforts to date in this regard.
sions of accounting and regulatory developments      It is important to conclude the current reform
enter a critical phase.                              program expeditiously.




44   ■   Restoring Confidence, Creating Resilience
Convergence                                           Standard-Setting Process
The G-20 and more recent official statements,          The IIF has continuously endorsed the indepen-
such as the U.S. Treasury’s proposals on              dence of accounting standard-setters. It is,
regulatory reform, have consistently stressed         however, part of the responsibility of indepen-
the importance of international accounting            dence to take account of economic and financial
convergence. It cannot be reiterated enough that      developments and respond in a manner coordi-
expedited convergence of accounting standards         nated between boards to achieve consistency
is a prerequisite to strengthening the compara-       across the main international standards.
bility of financial statements for investors and            Consistent with the recommendations of the
regulators as well as to preventing “accounting       G-20, it is in the best interests of independent
arbitrage.”                                           standard-setters and all market participants that
     Nevertheless, there remains ample risk of        the standard-setting process involve input from
fragmentation and national solutions, which may       all stakeholders, including preparers and users
result from inefficient communication between          of financial statements, as well as prudential and
standard-setters and official-sector decision-         securities regulators (including those of emerging
making bodies, given perceived tardy responses        markets). This is not only a procedural matter but
by the standard-setters to emerging crisis-related    also a substantive one that will improve trans-
issues.                                               parency and confidence in the standard-setting
     Rapid progress on reform and convergence         process and thus lead to a broader consensus on
is essential to preserving the credibility and        accounting issues.
independence of the standard-setters. Their                The IIF is supportive of the International
efforts to this end will need the active support      Accounting Standards Committee (IASC)
of all concerned, including especially securities     Foundation Monitoring Board as a means to
regulators and other authorities with oversight       embrace regulatory participation in the standard-
responsibilities. The standard-setters and other      setting process; however, prudential supervisors
concerned authorities should reaffirm prior            should participate fully in this scheme.
commitments in a clear plan for expeditious                There is a clear need for expedited due process
adoption of converged standards, eliminating          to develop interpretive guidance or revisions
existing directional and timing uncertainties.        of standards on occurrence of extraordinary
     There have been issues on which extraordi-       events or on rapidly changed market conditions
narily rapid action has been required, as discussed   or business practices. An established, expedited
further below. Even so, however urgent responses      process would contribute to avoiding divergence
to current issues or to parts of the G-20 agenda      between the major standards, facilitate greater
may be, these responses should remain well-           consistency in the application of accounting
coordinated and lead toward convergence.              standards, and reduce uncertainty and the risk of
                                                      a non-level playing field. A consistent expedited
 Recommendation 17: Achieving overall                 amendment process for official guidance,
 convergence in international accounting              standard setting, and disclosure also is essential
 standards requires active support from               to avoid ad hoc amendments to standards that, in
 all concerned, including the industry and            turn, may lead to voluminous and burdensome
 securities and prudential regulators. There          requirements that ultimately increase the
 should be a renewed commitment by all                complexity in financial reporting. Clearly it is
 stakeholders to a clear plan for timely adoption     vital for expedited procedures to be designed to
 of a single, high-quality set of accounting          further the goal of convergence for the benefit of
 standards.                                           users of financial statements.

                                                           Institute of International Finance • July 2009   ■   45
                                                      The recent changes made by the FASB illustrate
 Recommendation 18: Exceptional processes             the problem that analysis of credit deterio-
 should be in place to provide guidance on as         ration may give value signals that are distinctly
 expedited a basis as possible while allowing         dissimilar to other risk factors (for example,
 for rapid consultation with stakeholders in the      liquidity) that affect market valuations. Now it
 event of extraordinary occurrences.                  is imperative for the standard-setters to quickly
                                                      turn to the plan to develop common models that
                                                      reduce the existing multiplicity and complexity
Valuation and Impairment                              of different impairment schemes. New, simpler
                                                      approaches should be established on a basis of use
Valuation- and impairment-related issues              of all available, relevant information, as the G-20
caused great difficulties in the financial crisis.      has mandated.
Accounting guidance recently issued or currently
being debated on fair-value measurement in             Recommendation 19: While progress has
less-active markets is consistent with the goals of    been made to date on valuation in less-active
achieving clarity in the standards and promoting       markets, more needs to be done. Standard-
convergence. There has been wider recognition          setters should develop a common framework
of the appropriate role of management judgment         that reduces the complexity and multiplicity
in valuation discussions and the need to avoid         of existing impairment models on the basis of
mechanistic mark-to-market responses.                  all available relevant information. This should
    However, more can, and should, be done.            be done on a fully convergent basis, taking into
On valuation, the consistency of application of        account the lessons learned from the crisis.
accounting guidance for valuation in difficult
markets across firms and over time needs to be
solidified. More work in particular needs to be
done to integrate valuation adjustments into the      Fair-Value Accounting
process on an appropriate and transparent basis.      The IIF continues to be of the view that, while
The process should codify, on a fully convergent      fair-value accounting has clear benefits for both
basis, guidance on use of valuation adjustments       users and preparers of financial statements
for liquidity and other risk factors in various       for certain financial instruments, fair-value
market conditions.                                    measurement may not always provide the best
    Transparency of the valuation process is          reflection of cash flows due to a reporting entity
essential and, again, changes in guidance to date     operating on a longer term business model.
have been helpful but need to be integrated to        Work is in progress to improve the present mix
ensure clear understanding by all issuers, large      of fair-value and accrual accounting for financial
and small. While understanding of difficult            institutions. It is important to stress that the
market conditions has improved and the role of        next few months’ work by the two accounting
judgment is better understood, distortions caused     boards, in consultation with the industry and
by interpretation issues will be avoided only         other interested parties, will be crucial. Much
when final and converged guidance and standards        can be done. The IIF proposed suggestions for
are available and fully accepted by auditors and      the classification of financial instruments to
regulatory authorities.                               the International Accounting Standards Board
    Open discussion of the informational quality      (IASB) in connection with its joint project with
provided by existing impairment models has            the FASB on simplifying accounting for financial
begun but needs to be pursued as a top priority.      instruments.

46   ■   Restoring Confidence, Creating Resilience
     The IIF proposals are based on the premise             Furthermore, existing rigidities in hedge
that consistency between the accounting                 accounting18 lead to disincentives for preparers
framework and the reporting entity’s business           to elect hedge accounting treatment for financial
model is paramount for faithful representation          instruments carried at amortized cost. This
of the economic substance of transactions.              contributes to earnings volatility, as the hedging
Factoring in the firm’s business model provides          instrument will be carried at fair value while
a robust, objective standard and relates directly       the hedged item is not. The fair-value option
to fundamental business realities, facilitating         has helped reduce this volatility, as it provides
market discipline. Improvements to the allocation       users with the ability to achieve economic hedge
of assets between amortized-cost and fair-value         accounting without the associated risks and has
categories (as the IIF has proposed) will provide       a legitimate role in a simplified scheme, provided
better information to users by aligning reported        that issues related to gain and losses on an entity’s
values with the business model and use of assets.       own credit are resolved.
This approach also would allow the standard-
setters to address a number of the criticisms of             Recommendation 20: Fair-value accounting
fair-value accounting in the current environment.            has clear benefits in appropriate contexts.
     One particularly important aspect is the                However, questions have been raised
impact of any near-term changes in the classi-               concerning its effects on cyclicality, and it may
fication model on the financial statements of                  not always provide the best reflection of cash
insurance entities. Insurance business models                flows due to a reporting entity. Work currently
include holding financial assets for the medium               in progress to review fair-value and accrual
to long term to back insurance liabilities and for           accounting for financial institutions should
risk and asset liability management. Any change              continue with urgency. It should also address,
requiring measuring such assets at fair value                as part of the comprehensive simplification
through profit and loss would lead to artificial               of financial instrument reporting, existing
earnings volatility and accounting mismatches,               rigidities in hedge accounting.
given that insurance liabilities are not measured
on the same basis. It is vital for insurance entities
to be able to maintain the current “fair value
                                                        An Entity’s Own Credit
through other comprehensive income” category
of investments, at the very least until new             Reflection of changes in an entity’s own credit
standards on insurance contracts are effective.         standing in its earnings is another source of
     Dealing effectively with classification between     concern to many. While opinions on the utility of
fair-value and accrual accounting also should           recognizing changes in an entity’s own credit to
provide the basis for avoiding further divergence       provide meaningful information to investors are
between financial accounting and regulatory              divided, it is clear there is much discomfort with
capital requirements. Whereas it has been a goal        this aspect of fair-value accounting. The contro-
of all parties for years to maximize convergence        versy about recognition of own-credit changes
between the two regimes, an unfortunate effect of       extends both to the substance of the current rules
crisis-driven accounting controversies has been to      and also to the range of practices in their
cause some to conclude this may not be feasible.
Convergence rather than divergence between              18
the two should remain a high-priority goal of all         Hedge accounting requirements under U.S.
                                                        GAAP and IFRS require extensive documentation
concerned. A good result would contribute to
                                                        and substantial resources for assessment and
transparency and ultimately to stability.               measurement of hedge effectiveness.

                                                                Institute of International Finance • July 2009   ■   47
implementation. Importantly, it does not reflect          However, in recent years, securities regulators
management’s view of a firm’s liabilities.            have criticized “excess” provisions, with the result
    Extreme movements in credit spreads over         that preparers and auditors often have taken a
the past two years illustrate the widely made        much more restrictive approach to establishing
argument that recognizing changes of own credit      provisions than reasonable judgment about loan
in earnings often are not meaningful. This is        losses would suggest. Consequently, it appears
because it is commonly not possible for an entity    that a narrow interpretation of the incurred-loss
to realize the benefit of own-credit deterioration    model has become widespread in practice. This
by transacting in its own liabilities to any great   has had the unintended consequence of delaying
extent. The existence of credit deterioration        the recognition of portfolio loan losses, exacer-
may indicate that an entity is not in sufficient      bating the effect of procyclicality.
economic health to expend cash to realize the            In line with the recommendations of the
earnings benefit of retiring debt for less than its   FSB, the IIF has called for interpretive guidance,
notional amount.                                     authoritatively backed by the official sector,
    The IIF supports the current reconsideration     to enable practitioners to apply reasonable
of own-credit issues, which should include a close   judgment in assessing loan losses by taking into
examination of such factual issues, how they         consideration a broader range of available credit
complicate the use of the fair-value option, their   information. This will result in more consistent
impact on insurance accounting, and questions        and less procyclical loan loss practices that are
arising from the range of practice in implemen-      consistent with existing accounting literature.
tation of the current rules.                         The issue is whether management will feel
                                                     comfortable exercising judgment accordingly, and
 Recommendation 21: Reporting changes in             this depends largely on whether the auditors and
 an entity’s own credit in earnings is a source      securities regulators follow the standard-setters’
 of controversy. The debate should consider          guidance and accept provisions based to a greater
 whether elimination of recognition of changes       extent on professional judgment.
 in the reporting entity’s own credit quality in         Several official-sector reports, including those
 reported earnings would provide simpler, more       of Working Group 1 of the G-20 and the FSB,19
 direct, and more decision-useful information to     recommended a medium-term broader review
 the market.                                         of loan loss provisions by analyzing alternative
                                                     models that incorporate wider ranges of credit
                                                     information. With the objective of advancing
                                                     the discussion, the IIF submitted to the Financial
Procyclicality and Loan Loss Provisions
                                                     Crisis Advisory Group on behalf of members
Several official-sector commentaries have             two alternative proposals that incorporate credit
criticized the current incurred-loss provisioning    information that is not currently utilized under
model for exacerbating procyclicality on grounds     the incurred-loss model. One is a revised version
that, because of non-recognition of inherent loan    of the Spanish dynamic provisioning method
losses in portfolios, it may contribute to market    intended to recognize impairment earlier in the
pressure for high levels of dividends and share      economic cycle; the other is a proposal for a
buybacks and to distortion of compensation
                                                     19FSB, Report of the Financial Stability Forum on
calculations. Current accounting standards, in
principle, permit considerable management            Addressing Procyclicality in the Financial System,
judgment in establishing provisions.                 April 2, 2009.



48   ■   Restoring Confidence, Creating Resilience
change of standards to put provisioning on an
expected-loss basis similar to that in the Basel         Recommendation 22: Consistent guidance
capital accord. These proposals are now being            should be issued by the major standard-setters
debated as part of the reconsideration of the            to allow the use of reasonable interpretation
existing provisioning model.                             in assessing loan losses under the incurred-
     On the related issue of the treatment of            loss model. Such guidance should be given
accounting provisions for regulatory capital             the unambiguous backing of securities
purposes, it is clear that the regulatory capital        regulators in order to help avoid the overly
framework should not create disincentives for            narrow applications that have contributed
adequate provisioning; however, contrary to a fear       to procyclicality. The current review to
some have expressed, it does not appear to the           consider the reflection of a wider range of
IIF that the present rules limiting the inclusion        credit information in standards for loan loss
of provisions in Tier 2 capital have a substantial       provisioning must be given priority.
effect on provisioning decisions. On the contrary,
given that provisions will be more readily usable          The discussion above highlights challenges
if treated as reserves (that is, not included in       arising from the financial crisis that are still
regulatory capital), the present limited use of        being faced by accounting standard-setters.
provisions in capital should not be expanded.          While progress has been made to date, and the
     It is, of course, essential that provisions—as    IIF applauds these efforts, many issues remain
with any capital buffers or related reserves—          outstanding that require discussion and delib-
actually be usable against incurred losses as finally   eration by all constituents. It is important to
taken; any solution should be designed to allow        maintain an open and transparent dialogue that
provisions to be usable without accounting,            includes all interested parties, takes into account
regulatory, or market impediments. Therefore,          issues raised by the crisis, and balances the need
consideration should be given to excluding provi-      for urgent action with assessment of feasible
sions from capital altogether as a way to make         implementation.
provisions usable and also limit capital volatility.
Whichever regulatory treatment of provisions           3.6. LIQUIDITY
is decided on, it is fundamental that adequate
transparency be provided, as users of financial         The IIF issued an extensive discussion of liquidity
accounts should be able to determine clearly how       risk management in March 2007, updated in the
firms create and use provisions.                        July 2008 Market Best Practices Report, including
     However, regulatory policies on provisioning      recommendations for assessment of liquidity risk,
cannot deal with the issue of incentives in            liquidity buffers, and other risk mitigants. The
isolation. Tax rules play a fundamental role           Basel Committee published in September 2008 its
in provisioning decisions and ought to be              Principles for Sound Liquidity Risk Management
considered as part of any comprehensive review.        and Supervision. There is general consistency
                                                       between the IIF recommendations and the Basel
                                                       Principles, which the FSB found to meet the
                                                       G-20’s initial concerns on liquidity.
                                                           The Basel Principles, if properly enforced,
                                                       define a rigorous approach to liquidity risk
                                                       management and supervision. For reasons noted
                                                       below, any moves beyond those principles need to



                                                            Institute of International Finance • July 2009   ■   49
be carefully debated to avoid material unintended      exposure, balance-sheet leverage, and capital
consequences.                                          needs and also reduce unused wholesale funding
    Firms have already enhanced their liquidity        capacity, ultimately lessening the efficiency of the
risk management and, subject to difficult market        financial system overall.
conditions, have been building liquidity buffers           Following the Basel and IIF Principles, firms
and working toward compliance with the Basel           have substantially reinforced their liquidity risk
principles. In addition, they continue to manage       management. They increasingly set limits and
their liquidity to ensure that local liquidity needs   assess needs in each market. One aim of internal
can be met, using conservative assumptions and         liquidity risk management—and of its super-
setting local limits where appropriate.                vision by regulators—is to make sure that conser-
    As banks have been working to meet the Basel       vative assumptions are used and limits set. Firms
Committee’s principles, the insurance industry         may use more centralized or more decentralized
will need time to work with the IAIS to make sure      approaches, but the assessment of local market
the quite different liquidity issues that arise from   needs is always taken into account. The special
insurance activities are appropriately addressed.      needs of smaller currencies are, of course, part of
                                                       the analysis. And, of course, regulatory attention
 Commitment X: IIF members have already                to the quality of liquidity risk management has
 enhanced their liquidity risk management and,         been substantially increased.
 subject to difficult market conditions, have               The UK Financial Services Authority (FSA)
 been building liquidity buffers and working           has announced a proposal to require firms to
 toward compliance with the IIF and Basel              “ring-fence” assets of UK subsidiaries of foreign
 liquidity principles. In addition, they continue      firms in order to prevent another case of assets
 to manage their liquidity to ensure that local        being swept from a local operation prior to
 liquidity needs can be met. IIF Members will          a firm’s failure, as in the Lehman Brothers
 continue the ongoing enhancement of their             collapse.20 Other countries have announced
 approach to liquidity management.                     somewhat comparable measures.
                                                           From any country’s point of view, maximum
                                                       requirements might appear prudent, but this
                                                       can only put the brakes on global recovery,
Self-Sufficiency Approaches and Trapped
                                                       global finance capacity, and ability to respond to
Pools of Liquidity
                                                       global liquidity problems. The FSB Principles for
Both firms and the global financial system will          Cross-Border Cooperation on Crisis Management
be more resilient if firms are able to manage their     acknowledges that local ring-fencing complicates
liquidity needs on a group-wide basis. Central         firms’ funding plans.
treasury oversight of the firm’s liquidity opera-           Any local requirements should take into
tions is essential to good risk management and         account not only domestic needs and risks, but
proper internal pricing of liquidity. Major firms’      also the cumulative effects of such requirements
internal liquidity flows can contribute signifi-         on the global system. Also, whereas the risks of
cantly to sustaining liquidity in a global system.     market funding are now widely recognized, it
For these reasons, IIF members have argued             is paradoxical that ring-fencing may make local
strongly against local requirements that create        offices of global groups—which often do not have
“trapped pools of liquidity.” Unnecessary local        extensive retail deposit bases—more dependent
requirements that “trap” liquidity will unduly         20
increase each firm’s group-wide third-party credit        UK FSA Consultation Paper 8/22, Strengthening
                                                       Liquidity Standards, December 2008.


50   ■   Restoring Confidence, Creating Resilience
on wholesale market funding. Above all, such           with a more jurisdiction-focused approach
requirements should be consistent with the Basel       to allocation. Such an approach could give
principles and not implemented without careful         significant reassurance to national supervisors by
international coordination through the Basel           avoiding liquidity voids.
Committee and the FSB.                                     It remains unclear at this stage whether
                                                       such an approach would be feasible given
An Industry Contribution to Be Explored                legal constraints, differing risk management
                                                       techniques, and so forth. However, industry
One great obstacle to enhanced global regulatory
                                                       participants wish to explore with the official
integration, and a significant cause of resurgent
                                                       sector the extent to which such an approach
jurisdiction-specific self-sufficiency, is a fear that
                                                       might be feasible and productive. This could be a
in the event of the failure of a group, the stake-
                                                       useful issue for the FSB to take up in its capacity
holders of the jurisdiction in question will find
                                                       as coordinator of the activities of colleges of
themselves prejudiced in favor of stakeholders in
                                                       supervisors.
other jurisdictions.
     It has been suggested that one way for
                                                        Commitment XI: Good liquidity risk
the industry to help would be for the parent
                                                        management should take into account local
company of a group to provide guarantees for
                                                        market needs. In addition, the IIF is committed
its subsidiaries. This, however, does not solve the
                                                        to exploring ways in which firms could
problem, as in the end this produces a burden
                                                        organize their cross-border business to reduce
of broadly similar dimension for the group as a
                                                        the concerns of authorities that individual
whole in terms of combined liquidity and capital
                                                        jurisdictions would suffer disproportionate loss
requirements. In other words, it would replicate,
                                                        in the event of an insolvency. This should take
in modified form, the inefficiency that is sought
                                                        place in the context of the ongoing dialogue
to be avoided.
                                                        between large firms and the authorities
     An alternative suggestion would be for cross-
                                                        concerning the information necessary to plan
border groups to seek to carry on their liquidity
                                                        for the orderly exit of the firm should that
management in a manner such that in the event
                                                        prove necessary as discussed in Section 4. Such
of a failure of the group or part of the group, the
                                                        an approach would take into account the
extent to which losses fall disproportionately on
                                                        legal structure of the group and differences in
one jurisdiction as compared with another would
                                                        insolvency laws across jurisdictions. The IIF
be minimized. The aim would be to avoid the
                                                        stands ready to work with the official sector
undue prejudice of one jurisdiction over another.
                                                        to reduce the real dilemmas that the tensions
The operation of such an approach might be tied
                                                        between global and local goals for good
to the proposal in Section 4 for large or highly
                                                        liquidity management present.
interconnected firms to examine with their
authorities the risks that their role in markets and    Recommendation 23: Although the serious
products create to help the authorities assess what     issues raised by failures of major market
would happen in the event of their failure.             participants need to be addressed, the
     Such an approach would take into account the       significant drag on system efficiency created by
legal structure of the group and be subject to the      “trapped pools of liquidity” also is important
constraints of law, including differences of insol-     and needs to be taken into account. Self-
vency laws across jurisdictions. The effect of this     sufficiency or stand-alone approaches to
might be to achieve a combination of “top-down”         liquidity regulation should be resisted by
calculations of the liquidity needs of the group        regulators.


                                                            Institute of International Finance • July 2009   ■   51
Liquidity Buffers                                       Eligible Assets for Liquidity Buffers
Liquidity buffers raise different cyclicality           The UK proposals confine assets eligible for
issues from capital buffers. Whereas loan loss          liquidity buffers narrowly to a limited list of state
expectations naturally move with the credit             obligations.21 Such requirements are not without
cycle, liquidity risk is not smoothly cyclical but      logic from one viewpoint, but they go too far and
instead tends to move suddenly in response to           may have several unintended consequences if
market incidents. Thus, an extremely conservative       adopted broadly.
approach to liquidity buffers would require                 A restrictive definition of eligible assets, and
very high liquidity buffers at almost all times         the need for extensive portfolios of such assets
as insurance against “perfect-storm” conditions         for liquidity buffer purposes, will necessarily
that would be much less predictable than credit         affect the markets for eligible and ineligible
cycles. This would be counterproductive from an         assets. Eligible assets, if defined too narrowly,
economic viewpoint.                                     may actually become significantly less liquid, as
    As part of the further development of interna-      they will need to be held in large amounts for
tional practice on liquidity buffers, it is important   liquidity buffer purposes. The negative effects on
to agree on when or under which scenarios a             non-eligible traded debt markets will delay their
bank can actually use its liquidity buffers. The        recovery, increasing reliance for finance on bank
circumstances under which buffers will be able          loans, thereby creating pressure on bank liquidity.
to be drawn down must be clearly defined and                 The mark-to-market effects of many firms’
accepted by all parties in order to have the desired    disposition of a narrow category of eligible
effect.                                                 assets also need to be taken into account. If,
    Prior IIF work has demonstrated at length           in a systemic event, many firms sought to use
that regulatory liquidity requirements cannot be        the same assets, prices would be depressed,
applied across the board and that one-size-fits-all      and markets could seize up, triggering another
requirements will end up with distorted incen-          downward spiral.
tives and missed risks.                                     Rather than setting a priori requirements,
                                                        it would be better both for overall liquidity and
  Commitment XII: It is necessary to hold               for the market as a whole if requirements allow
  liquidity buffers against liquidity risk. This is     for a range of solutions, based on objective
  an important part of a robust overall approach        liquidity analysis. Any analysis that excludes
  to liquidity risk management.                         a class of asset that is eligible at major central
                                                        banks in ongoing operations should be carefully
  Recommendation 24: In determining a firm’s
  liquidity buffer, mechanistic approaches that         21From Strengthening Liquidity Standards: “The assets
  do not take into account the overall business         in the buffer should be the most liquid by virtue
  model, funding profile, and market context of          of the significant depth and resilience in stressed
  the firm are likely to be counterproductive and        conditions of the established markets in which they
  should not be adopted.                                are traded. We consider these to be:
                                                          Highly liquid, high-quality government debt
                                                          instruments as follows: gilts, plus bonds rated at
                                                          least Aa3 issued by the countries of the European
                                                          Economic Area, Canada, Japan, Switzerland, and
                                                          the United States; and
                                                          Reserves held with the Bank of England’s reserve
                                                          scheme and with the central banks of the United
                                                          States, the EEA, Switzerland, Canada, and Japan.”

52   ■   Restoring Confidence, Creating Resilience
considered; exclusion of a central bank–eligible        prudent or useful to set liquidity limits across
instrument may have significant and unnecessary          many firms. Rather, rigorous definition of the
consequences, depending on the facts and                metrics and limits to be applied to a given firm’s
circumstances. IIF recommendations always have          business needs to be subjected to extensive stress
made clear that the first line of defense is not the     testing, as also discussed in prior work. Assump-
central bank; however, central bank–eligible assets     tions, hurdle amounts, and other parameters need
will generally have the ability to generate cash by     to vary with the circumstances of a given firm in
sale, repo, or other use as collateral in the market.   its markets, taking into account legal entity and
     In determining the marketable assets available     other considerations, and they need frequent
for liquidity buffers, the specific range of liquidity   reevaluation.
needs to be met must be considered. Assets that              It would, however, be desirable to develop
can be monetized (that is, disposed of or used          international agreement on standard liquidity
as collateral) on a one-week basis may provide          reporting requirements and formats (as, indeed,
substantial coverage, whereas limitation of buffers     the UK FSA has suggested). Having to produce
to, say, assets that can normally be monetized          inconsistent external reporting requirements
overnight may add unnecessary rigidity. Going           will create substantial burdens and chances for
further, a firm may have spare stable funding            error by firms, distracting management attention
from relationship deposits; dependable, unused          from the more acute and actionable internal
capacity from wholesale sources; or reliable            liquidity metrics, and undermine the cause of
commitments. Thus, the important issue is to            international regulatory cooperation. This is not
have a high degree of confidence, demonstrable           just a matter of the formats, scope, and granu-
to the supervisor, that these sorts of liquidity will   larity of reporting but instead goes to the need to
be accessible when needed. It also will often be        harmonize fundamentals, such as definitions of
appropriate for smaller institutions to hold paper      ratios and basic terms.
issued by larger institutions as part of a diversified        Another issue concerns the extent of public
portfolio of assets.                                    disclosure. While it is appropriate to disclose
                                                        information on liquidity risk management
  Recommendation 25: Overly narrow                      frameworks, disclosure of liquidity positions
  definitions of eligible liquid assets for liquidity    as such can be destructive of liquidity, and any
  buffers should be avoided as a matter of              new requirement should be studied carefully to
  proportionality and to avoid unintended               provide market-useful information while at the
  consequences. The definition of eligible assets        same time not undermining systemic stability.
  should be both coordinated internationally
  and developed in tandem with revised (and              Recommendation 26: There should be
  coordinated) central bank lists of eligible            comprehensive international coordination.
  collateral for ongoing monetary operations and         This includes liquidity reporting requirements,
  (non-emergency) liquidity purposes.                    as proliferation of detailed but inconsistent
                                                         requirements across jurisdictions will impose
                                                         undue burdens and costs, contribute to systemic
                                                         vulnerability, raise compliance risk, and
Tools, Metrics, and Benchmarks
                                                         distract from the clarity of internal reporting to
As the IIF work on liquidity argues, and as recog-       management.
nized in the Basel Principles and the FSA consul-
tative paper, it is unlikely that one metric will be



                                                             Institute of International Finance • July 2009   ■   53
Core Funding                                           wholesale deposits, may, in fact, be highly stable
                                                       “relationship deposits” for a number of business
A firm’s funding is central to the equation. On the
                                                       reasons, whereas some forms of retail deposits
one hand, stability and diversification of funding
                                                       (for example, brokered and “teaser-rate” deposits)
may lessen the chance of recourse to buffers; on
                                                       may be less stable. In fact, overly rigid require-
the other hand, excessive reliance on wholesale
                                                       ments to build retail deposits would lead to
funding without adequate planning can be fatal,
                                                       competition for them, which would actually make
as with Northern Rock. Considerations for firms’
                                                       them less sticky and less stable. Thus, as in many
funding plans are discussed extensively in the
                                                       other areas, a funding ratio may be a useful point
prior IIF reports.
                                                       of reference, but it should not become a rigid
    The UK’s Turner Review calls for consid-
                                                       quota.
eration of a core-funding ratio to “ensure
sustainable funding of balance sheet growth”
                                                        Commitment XIII: The IIF agrees that a
and it is understood that this topic features in
                                                        significant component of funding should be
current regulatory discussions. In these discus-
                                                        comprised of stable elements, as part of well-
sions, there is a tendency to stress the importance
                                                        understood overall funding plans.
of deposit funding, and this is appropriate.
However, it must be remembered that a hard-             Recommendation 27: A strict, mandatory
target core-funding approach would likely reduce        core-funding ratio should not be adopted. Such
overall lending capacity, as there are limits to the    an approach is unlikely to reflect different
extent of reliance on “retail” deposit funding.         degrees of stability and would be prone to
The assumption that retail deposits (however            material unintended consequences (such as
defined) are the most “sticky” may obscure the           an increased volatility that would result from
fact that certain classes of small and medium           enhanced competition for deposits).
enterprises (SME) and corporate and institutional




54   ■   Restoring Confidence, Creating Resilience
     SECTION 4

Financial Stability Through Macroprudential Oversight




4.1. SYSTEMIC RISK AND THE NEED                       Challenges Ahead
     FOR CHANGE                                       Despite progress, it is clear that many significant
Significant consensus has been reached that the        challenges remain to be overcome, including the
financial system as a whole—on both the market         establishment of an effective response mechanism
and regulatory sides—was poorly equipped to           at the international level to ensure that macro-
deal with systemic risks. Progress has already        prudential analysis is effectively “translated” into
been made to rectify this problem. For example,       practical proposals to address emerging risks.
recent months have seen the reconstitution of         The IIF has previously proposed establishment
the Financial Stability Forum as the FSB, the         of a Global Financial Regulatory Coordinating
enhancement of its mandate, and the expansion         Council made up of central banks and super-
of its membership. The role of the International      visors and responsible to the FSB, and continues
Monetary Fund (IMF) has been expanded and the         to believe that this would be helpful.
importance of the IMF–FSB nexus emphasized.               Whatever institutional form is adopted, what
                                                      is important is the ability to bring a focused and
Some Industry Steps                                   technically complete analysis to bear in devel-
                                                      oping policy proposals for giving effect to macro-
The industry fully shares the view that this is       prudential concerns identified by the IMF and
a key area for significant attention. The IIF’s        others.23 The newly mandated FSB is an essential
MMG, under the cochairmanship of Jacques de           first step, but it is likely that its resources will need
Larosière and David Dodge, and consisting of          to be augmented to achieve these goals.
seasoned experts from across financial markets             In this section we focus on a few aspects of
and sectors, will consider market developments,       financial stability and macroprudential oversight.
vulnerabilities, and potential dynamics giving rise
to systemic risk in the form of mispriced assets,     23 We note the reasoning contained in the European
crowded trades, concentration risk, or emerging       Commission’s communication of May 27, 2009,
risks of which the industry must be aware.22 It       on European financial supervision: that individual
will explore ways to mitigate such risks, and share   finance ministries should not be included in the
its concerns and views with official-sector bodies,    European Systemic Risk Council (ESRC) as this
in an effort to strengthen systemic soundness.        could be perceived as blurring its role in providing
                                                      independent technical analysis of macroprudential
22   See www.iif.com/press/press+99.php.              risks.




                                                           Institute of International Finance • July 2009   ■   55
                                                       All Systemically Relevant Entities to Fall
 Commitment XIV: The IIF’s recently-                   Within Macroprudential Oversight
 established Market Monitoring Group is
 committed to identifying and assessing                While the goals, means, and implications of
 systemic vulnerabilities and issues emerging          financial stability oversight and regulation need
 in the markets. It stands ready to discuss such       much further consideration, certain aspects
 developments with the official sector.                 already can be identified.
                                                           Financial stability is not a fixed or static
 Recommendation 28: Macroprudential                    concept; it is rather the ability of the whole matrix
 analysis at the international level will need         of financial entities and relationships, products,
 to be translated into actionable measures for         and infrastructure to support economic activity,
 implementation. Given the G-20’s mandate              manage risks, and absorb shocks on an ongoing
 to the FSB, the FSB’s resources should be             and reasonably predictable basis, without major
 augmented for this purpose.                           disruption or discontinuity. Effective regulation
                                                       and oversight must be designed and developed
                                                       having regard to the continually evolving and
                                                       multifaceted nature of the risk.
4.2. SYSTEMIC RELEVANCE                                    Oversight must extend, therefore, not
An Important Consensus for Change                      only to financial firms but also to markets and
                                                       products, risks, and incentives. The IIF has
The G-20 leaders agreed at their April 2, 2009,
                                                       taken the position that all market participants
meeting that all systemically important financial
                                                       whose activities could materially affect systemic
institutions, markets, and instruments should be
                                                       stability should fall within the framework
subject to an appropriate degree of regulation
                                                       of macroprudential oversight, including all
and oversight. In particular, the leaders agreed
                                                       significant financial markets, products, and risks.
to amend their regulatory systems to ensure
                                                       In respect to firms, this should apply regardless
authorities are able to identify and take account of
                                                       of legal nature or form of license. Oversight and
macroprudential risks across the financial system
                                                       information gathering, of course, need to be
and to limit the build-up of systemic risk. They
                                                       distinguished from more substantive forms of
said that large and complex financial institutions
                                                       direct regulation.
require particularly careful oversight given their
systemic importance.
                                                       A Question of Degree in the Systemic
    This theme has been widely echoed in, for
                                                       Relevance of Firms
example, the de Larosière Group report, the
Turner Review, and the recently published U.S.         Systemic relevance is a question of degree and
Treasury proposals.                                    relates to a spectrum of potential impacts of
    The IIF agrees that financial stability oversight   failure. It is thus not a binary question whether a
needs significant enhancement. Risks developed          particular firm should be categorized as “systemi-
in the system that neither the industry nor            cally relevant” or not. The manner in which
official-sector participants were in a position to      the failure of different firms could give rise to
manage. It is essential that for the future a full     systemic effects takes a wide variety of forms.
complement of macroprudential and financial                  For example, some firms may be neither
stability oversight techniques be firmly in place—      particularly large nor highly interconnected with
from surveillance and risk identification, through      the overall system. Nonetheless, they can have
analysis and dialogue, to tools for intervention.      a material degree of systemic relevance owing
                                                       to a concentrated role in particular markets or

56   ■   Restoring Confidence, Creating Resilience
products or to the impact that their failure would        interconnectedness should be developed so
have on confidence. Similarly, as discussed in             that well-adapted mitigating techniques can
Sub-section 2.3, it is important to differentiate         be put in place. A tendency to see systemic
appropriately between different activities such as        risk mainly through the prism of a certain
banking and insurance which give rise to varying          number of large firms would not be the
risk profiles.                                             most conducive to achieving this.
    The establishment of a formal category of             Many of the concerns associated with
institutions deemed systemically relevant—                systemic relevance can be mitigated through
whether public or not—would be unlikely to                addressing the interdependencies of firms
produce positive outcomes. It would inevitably            in the market. Thus, central counterparties
be drawn either narrowly—thus giving rise to              and improvement of regulation for many
undesirable rigidities and incentives to manage           OTC products, reinforcing payment systems,
around boundaries, and other unintended                   and managing interbank exposures through
consequences—or broadly so as to undermine its            large-exposure limits, all of which are being
meaningfulness. Moreover,                                 developed in relevant jurisdictions, will do
                                                          much more than conceptually and techni-
     The fact of the definition of such a category         cally difficult limits on a defined category of
     would tend to reinforce the impression that          firms.
     the main sources of systemic risk had been
     identified and were being controlled. This
     could lull the markets and contribute to the    Systemic Relevance of Firms Key Issue
     tendency in benign periods to underestimate     for Supervisors
     risks.
                                                     Although sharp or formalistic definition of a
     Risks would tend to migrate away from this
                                                     category of systemically relevant firms is likely to
     category of firms to other, perhaps less-well-
                                                     be counterproductive, as discussed in Section 2 a
     understood or -controlled holders. Such
                                                     risk-based approach including systemic risk is an
     dispersion would not mean that the risks
                                                     essential component of high-quality supervision.
     had been reduced or eliminated, but it could
                                                     It is necessary for supervisors to develop a clear
     contribute to underestimation of risk in the
                                                     understanding of the degree to which, and the
     system.
                                                     manner in which, any particular firm can pose
     Perception of firms formally categorized
                                                     a threat to systemic stability, either individually
     as highly systemically relevant would be
                                                     or collectively with others. Supervisors should
     distorted. They would likely be seen as
                                                     tailor their approach to supervision, including
     considered officially too big to fail and as
                                                     its intensity, having regard to such analysis and
     benefiting from some form of implicit state
                                                     understanding.
     guarantee thus increasing moral hazard.
                                                          The IIF welcomes the fact that the IMF, in
     By reducing market discipline, this would
                                                     consultation with the FSB and the Bank for
     render the system less, not more, resilient.
                                                     International Settlements (BIS), is developing
     Identifying and obtaining a clear under-
                                                     common international framework and guidelines
     standing of systemic relevance in all its
                                                     to help authorities deal with the question of
     varieties and forms is essential. The most
                                                     the scope of financial stability oversight and
     important reason to do so is to ensure that
                                                     regulation and the intensity of risk presented. We
     the most effective means to mitigate such
                                                     look forward to engaging with the IMF, FSB, and
     risks are in place. A multifaceted under-
                                                     other organizations as this process advances.
     standing of the many forms and features of

                                                          Institute of International Finance • July 2009   ■   57
Information and Power to Intervene                          The IIF agrees that how to address the
                                                        risks associated with the existence of very large
It is essential that those responsible for financial
                                                        participants is an issue that requires consider-
stability oversight have access to all relevant and
                                                        ation. However, the solution lies in a number
material information to permit them to carry out
                                                        of approaches rather than in any one measure
risk identification and analysis. They should have
                                                        focusing on the variable of size.
the power to bring sources of newly identified
                                                            There appears to be an emerging, but not yet
risks within the scope of direct regulation, subject,
                                                        universal, consensus among the official as well as
of course, to due process and deliberation.
                                                        the private sectors that it would be very difficult
     There is, however, concern that, perhaps
                                                        and ultimately undesirable to seek to limit the size
understandably in the immediate circumstances,
                                                        of particular firms.
supervisors often request very large amounts of
                                                            Even if putting a priori limits on firm size
information from firms without it being wholly
                                                        were achievable, there is a real possibility that the
clear how this information can, in fact, be assimi-
                                                        systemic risk associated with large entities would
lated and used and for what purpose. It is very
                                                        simply come to reside in a number of smaller but
important that information gathering be useful,
                                                        interconnected entities that would have become
proportionate to the ends in view, and based to
                                                        in effect “large by network” rather than by
the maximum extent possible on consistent inter-
                                                        corporate structure.
national reporting formats and requirements.
                                                            Similarly, we do not consider that the case
                                                        has been made for “narrow bank” or “new Glass–
  Commitment XV: The IIF agrees that
                                                        Steagall” business restrictions on certain banks
  authorities will require access to all relevant
                                                        (generally those with access to deposit insurance
  and material information to carry out effective
                                                        and central bank liquidity), as has been recently
  financial stability oversight. The industry will
                                                        suggested by some.
  work with regulators to identify and provide
  such information.
                                                        Benefits of Large, Diversified Banks
  Recommendation 29: It would be
                                                        As discussed in Section 1, significant benefits
  counterproductive to create a formal or
                                                        come from large, cross-border banks engaging in
  published category of highly systemically
                                                        a range of activities.
  relevant firms. Systemic risk does not reside
                                                            Such institutions play a key role in supporting
  in single entities but in the interconnectedness
                                                        a globalized economy. They make a significant
  of firms, markets, and players. It is a rapidly
                                                        contribution to ensuring diversity of choice for
  evolving and multifaceted concept that should
                                                        both investors and users of funds and facilitating
  be addressed using appropriately sophisticated
                                                        the efficient transfer of funds from countries with
  and adaptive techniques, which avoid
                                                        “excess” savings to locations in need of funds.
  distortions and moral hazard.
                                                            Large, globalized commercial and industrial
                                                        firms benefit from large, global financial partners
                                                        that they can rely on for sophisticated, high-value
4.3. ROLE OF LARGE BANKS                                services on a consistent basis. Requiring them to
                                                        shift to smaller providers would certainly increase
Closely related to the issue of systemic relevance      the cost and complexity of their business.
is the question of whether some firms are so large           Large, well-managed banks make an
that they pose an unacceptable risk. “Too big to        important contribution to systemic resilience.
fail” has become a subject of intensive interna-        In circumstances in which external markets are
tional discussion.

58   ■   Restoring Confidence, Creating Resilience
under pressure, the “internal capital markets” of       IndyMac were casualties with perceived systemic
such institutions can continue to provide capital       impact as the crisis developed.
and liquidity in places where it is badly needed.            As is stated in the UK Treasury’s proposals
                                                        Reforming Financial Markets, “there is little
Artificial Restrictions Not the Answer                   evidence to suggest that artificial restrictions
                                                        on a financial institution’s size or complexity,
The IIF concludes on the basis of members’
                                                        including introducing a distinction between
experience that the artificial restrictions that have
                                                        commercial and investment banking activity,
been suggested by some would deprive the global
                                                        would automatically reduce the likelihood of firm
economy of the benefits provided by large, diver-
                                                        failure....” 24
sified institutions. At the same time, such restric-
                                                             During the recent crisis, many groups found
tions would not make a positive contribution to
                                                        resilience in diversified business models, and
the resilience of the system or to ongoing stability.
                                                        one of the most successful national responses
    Indeed, the unintended consequences of
                                                        (Canada’s) was based on resilient universal banks.
such restrictions, which would inevitably warp
                                                        By requiring certain activities to be carried out
incentives, would be severely deleterious. Risk
                                                        elsewhere or size to be limited, such natural
distributions would likely become distorted
                                                        resilience would be lost.
and more difficult to identify and manage. The
                                                             Moreover, while a number of large firms as
overall resilience of markets founded on robust
                                                        well as small ones found themselves in difficulties
competition between well-managed firms would
                                                        during the recent period, it was other large firms
be undermined, as might be the capacity of
                                                        that were in a number of important cases called
firms to invest in further development of risk
                                                        on to play a key role in the safe resolution of
management.
                                                        less-well-managed firms that were on the brink of
    As discussed above, systemic risks do not
                                                        failure.
reside simply in single large entities but rather
                                                             Moreover, there would be considerable
in the full constellation of interconnected firms,
                                                        practical difficulties in the imposition of global
markets, and products. As was pointed out by the
                                                        size or business-model restrictions. It would be
de Larosière Group, significant risks can arise as a
                                                        very difficult, if not impossible, to determine
result not of the failure of one large firm but from
                                                        the appropriate size limits and to implement
the common exposure of many financial institu-
                                                        them as firms approached the limits. As for
tions to the same risks. It would therefore be
                                                        activity restrictions, to proscribe certain activities
mistaken to believe that the problem of systemic
                                                        would be likely to significantly hamper firms in
risk can be addressed by limiting the size or
                                                        providing a reasonable range of expected services
activities of firms.
                                                        to their client base and would certainly restrict
    For example, many of the systemic events
                                                        the future pace and scope of innovation within
of recent times were triggered by problems in
                                                        the environment of sound risk management that
institutions that would not be considered particu-
                                                        well-managed and well-supervised large firms can
larly large. Trust and confidence are two essential
                                                        provide.
ingredients of a functioning financial system, and
                                                             It is important to the future success of
once these are undermined, events can unfold
                                                        the global economy that the financial services
very quickly, irrespective of which particular
                                                        industry be run both soundly and profitably. This
institutions trigger events. This was clearly shown
                                                        means that leading participants need to be able to
in the current crisis, in which comparatively small
                                                        engage in a range of activities covering a variety
or “narrow” institutions such as Northern Rock,
                                                        of risk types. In addition, firms’ ability to partic-
IKB, Sachsen Landesbank, Hypo Real Estate, or
                                                        24   July 2009, p. 74.

                                                                Institute of International Finance • July 2009   ■   59
ipate in markets and take positions is important             Moreover, as discussed above, the IIF supports
to their ability to support the economic activity       a risk-based approach to supervision, where the
of real-economy businesses. To limit the ability        determination of risk involves weighing both the
of firms to engage in well-managed proprietary           probability of an event and its likely impact. It is
activities is likely to have a very distorting effect   both desirable and appropriate for supervisors to
and ultimately to hinder a return to full ability to    give a central role to systemic risk in the deter-
serve clients and maintain markets.                     mination of their approach to the supervision of
                                                        a particular firm. It should be expected that the
Better Solutions                                        supervision of a firm will be more intensive where
                                                        the failure of the firm would have a material
The presence of large, diversified, cross-border
                                                        impact on the system.
institutions brings many benefits to the global
                                                             In general, while it may be appropriate to
economy and to individual countries and their
                                                        apply more intensive supervision to larger firms,
citizens. As imposing artificial limits on size
                                                        for the reasons discussed above we do not believe
or activities would be harmful in practice and
                                                        that it is appropriate to apply different regulations
unlikely to succeed in reducing overall levels of
                                                        to firms purely based on the size or because they
systemic risk, the question becomes how best to
                                                        are determined to fall within a predetermined
address the problem of the potential impact of
                                                        category of high systemic relevance.
the failure of such institutions (and, indeed, other
                                                             However, in accordance with a risk-based
institutions of systemic importance).
                                                        approach to supervision, it is appropriate for
                                                        supervisors to take into account the degree of
Improved Risk Management
                                                        systemic relevance of a firm in carrying out its
First, large, diversified, cross-border institutions     supervisory review of the firm. This means that
must achieve a very high degree of soundness,           supervisory measures applied to a firm including,
stability, and quality of risk management. With         for example, requirements to improve risk
the publication of the IIF Market Best Practices        management or, ultimately, to require additional
Report last year, the industry collectively began the   capital, should legitimately take account of the
task of achieving higher quality risk-management        systemic impact of such a firm should it fail.
standards across the piece. Work is continuing
strongly across the industry to implement the             Commitment XVI: The IIF agrees that the
recommendations in that report (see Section 2).           degree of systemic relevance of a firm may
The standards set out in the report have become           require more intensive supervision. Members
widely accepted as sound standards of risk                are committed to working with supervisors to
management and have become an important part              make such an approach effective.
of supervisors’ dialogue with firms.
                                                          Commitment XVII: The IIF agrees that
                                                          the supervisory review process applied to
Enhanced Regulation and Supervision
                                                          firms should be founded on a risk-based
The range of regulatory reform that is under              approach. Accordingly in determining what
way will make a significant contribution to                if any supervisory measures should be taken,
ensuring high levels of soundness and quality of          supervisors should incorporate analysis of the
risk management in large banking institutions.            nature and degree of a firm’s impact on the
Key aspects of this regulatory reform agenda are          system should that firm fail. Members are
discussed in Section 3 of this Report, and we do          committed to working with supervisors to make
not repeat them here.                                     such an approach effective.


60   ■   Restoring Confidence, Creating Resilience
More Resilient Infrastructure                           Contingency Planning for Insolvency
Recent history shows that the interconnectedness        Experience with the Lehman Brothers failure
of firms in global markets is much more a cause          in particular has shown that insolvency of a
for concern than size or business model as such. It     large and complex firm operating in multiple
is possible to enhance the resilience of the system     jurisdictions poses many technical as well as legal
as a whole, including its interconnectedness, by        problems. This has in turn suggested that the task
improving infrastructure so as to make it much          of the administrators and regulators coping with
less prone to instability and risk contagion in the     the aftermath of a failure would be made easier
event of the failure of a large firm. The progress       and the process more orderly if there were more
that has already been made by the industry and          prior planning.
the official sector in reducing the level of bilateral        Gov. Mervyn King put it that “making a
counterparty exposure arising from credit               will should be as much a part of good house-
derivatives and from OTC derivatives generally          keeping for banks as it is for the rest of us.”25
through the increased use of CCP techniques is          It is debatable whether this analogy is tenable
a good example of this. Work should continue            for a large, ongoing business. It is more likely
over the coming months to consider further              to be productive for firms to examine with the
improvements that might be made to reduce               authorities the risks that their roles in markets
systemic risks arising for infrastructural and          and products create, so as to help the authorities
interconnectedness reasons. Similarly, the risks        assess what would happen in event of their failure.
of securitization markets are now much better           Moreover, given the objective of making failure
understood, and the structures for simpler, more        a realistic threat, the ongoing dialogue between
transparent, and more liquid markets are already        large firms and their authorities should include
being developed (see further Section 5).                consideration of all the information necessary to
                                                        plan for the orderly exit of the firm should that
Making Orderly Exit Possible                            prove necessary.
                                                             Such planning should be developed in close
As already discussed at Sub-section 2.4, the
                                                        collaboration with supervisory colleges. The IIF
plausible threat of loss is the foundation of
                                                        firmly believes that for such an approach to be
market discipline. An important part of making
                                                        successful, it is essential that such dialogue be
it credible that investors and creditors of a major
                                                        carried out in confidence between the firm and
firm would suffer the consequences of failure
                                                        its relevant authorities. Public disclosure could
will be to put in place significantly enhanced
                                                        undermine stability by giving market counter-
procedures and mechanisms for dealing with
                                                        parties a road-map to the firm’s intentions,
financial crises, in particular cross-border crisis,
                                                        facilitating the taking of positions against it.
and for the winding-up of large or systemically
                                                             In summary, therefore, the too-big-to-
important institutions. The essential goal is to
                                                        fail question is a legitimate one for debate.
make it feasible for such institutions to fail in
                                                        The solution lies not in fiat limits on size
a non-disruptive fashion, that is, to be able to
                                                        but in a range of measures designed first to
exit the market in an orderly and reasonably
                                                        ensure soundness and the highest quality risk
predictable manner (see Sections 6 and 7).
                                                        management in such firms and second to make
                                                        it more practicable for major firms to exit the
                                                        market in an orderly manner, should that prove
                                                        necessary.
                                                        25   Mansion House Speech, June 17, 2009.

                                                                Institute of International Finance • July 2009   ■   61
 Recommendation 30: Artificial restrictions on         4.4. MICROPRUDENTIAL
 size or diversification should be avoided. Large,          SUPERVISION
 complex institutions play an important role in       As discussed in Section 2, developing effective
 supporting the global economy. Restrictions on       techniques for the microprudential supervisory
 size or diversification could produce materially      implementation of macroprudential oversight
 distorting effects and unmanageable risk             is a significant challenge. The new task of incor-
 patterns within the system. The industry agrees,     porating macroprudential analysis and insights
 however, that in addition to ensuring that such      into the microprudential supervision of firms
 institutions meet the highest standards of risk      will require an outcomes-focused, risk-based
 management, it is essential that they be subject     approach that creates incentives for strong risk
 to effective market discipline. To this end, there   management.
 should be developed the infrastructural, legal,
 and process reforms necessary to ensure that all     Global Supervisory Colleges ... Role of
 firms can exit the market in an orderly fashion       the FSB
 without causing undue trauma to the system.
                                                      As discussed in Sub-section 1.3, group-wide
 Recommendation 31: Restrictions on the               effective and efficient supervision, in both the
 business models or range of activities of firms       macro- and microprudential dimensions, requires
 should be avoided. While it may be appropriate       integration, ideally seamlessly, of supervisory
 to require additional capital in respect of          activities and macroprudential analysis across
 higher risk activities, there is no good case to     all relevant regulators. The smooth operation
 prevent firms from engaging in a full range of        of global supervisory colleges is crucial, and the
 financial activities in accordance with sound         industry welcomes recent progress that has been
 and well-managed business models. Far from           made in this regard under the leadership of the
 being a source of vulnerability, diversified, well-   G-20.
 managed, and profitable firms provide a source              In order to ensure the effective “bridging” of
 of real resilience for the overall system.           macroprudential oversight and microprudential
 Commitment XVIII: Consistent with the                practice, the FSB should do the following:
 principle that no firm should be designated too
 big to fail, large or highly interconnected firms       • Develop and regularly review joint interna-
 should examine with the authorities the risks            tional strategies that set the macroprudential
 that their role in markets and products create, to       framework for the supervisory activities at
 help the authorities assess what would happen            the microprudential level;
 in event of their failure. The ongoing dialogue        • Implement these strategies through
 between such firms and their authorities should           coordinated horizontal and, as appropriate,
 include consideration of all the information             thematic work across the peer group and
 necessary to plan for the orderly exit of the firm        across the responsible national micropru-
 should that prove necessary.                             dential regulators; and
                                                        • Ensure close coordination and cooperation
 Commitment XIX: Riskier activities should be             within and, importantly, consistency across
 subject to appropriately risk-weighted capital           the supervisory colleges set up for the
 requirements. Such capital requirements should           multinational firms in the peer group.
 be calibrated so as to reflect the risk of those
 activities and consideration should also be given        In addition, it will be necessary for colleges
 to relevant cost of funding issues.                  to look to the efficiency and consistency of the

62   ■   Restoring Confidence, Creating Resilience
regulatory process across each group, for example     established an industry platform representing
on reporting and Pillar 2 analysis.                   the large European banking groups subject to
                                                      college-based supervision. This platform interacts
 Recommendation 32: The FSB should                    directly with a Committee of European Banking
 coordinate the engagement of supervisory             Supervisors (CEBS) sub-group mandated to
 colleges in the implementation of the policy         help coordinate college-based supervision of the
 conclusions arising from macroprudential             participating banking groups.
 oversight and analysis, as well as in the                A similar platform representing the multi-
 assessment of emerging financial stability risks.     national financial institutions for which global
                                                      supervisory colleges have been established
                                                      would provide feedback on the microprudential
                                                      operation of the global colleges. It could help
Interaction with the Industry
                                                      communicate and implement the FSB’s macro-
The IIF stands ready to contribute via its MMG        prudential strategies into the microprudential
(see Section 4) to the FSB’s macroprudential          activities of the global colleges across the peer
analysis and the formulation of international         group. Significant added value could be expected
strategies setting the macroprudential framework      in particular from the interaction and cooper-
for the microprudential activities of the global      ation with the industry platform in relation to the
colleges. The MMG would be well placed to bring       horizontal, thematic work of the global colleges.
to the fore the industry’s view on systemic vulner-
abilities and cyclical risks. It also could draw       Recommendation 33: To achieve
the FSB’s attention to possible improvements of        macroprudential aims effectively and
market practices and infrastructures.                  efficiently, a structured international dialogue
    In contrast, the implementation of strategies      should be put in place between authorities
through microprudential activities and the             and firms. This should involve an industry
day-to-day operation of the global colleges will       platform, representing firms subject to FSB
warrant a separate dialogue with the industry.         colleges and the supervisors involved in those
The FSB may wish to consider replicating the           colleges.
approach taken in the EU, where there has been




                                                           Institute of International Finance • July 2009   ■   63
  SECTION 5

Improving Market Infrastructure and Mitigating Risks
of Interconnectedness


5.1. BENEFITS AND RISKS                                 did not. Owing in part to the identification of
                                                        potential weaknesses and action taken over recent
A wide range of factors contributed to the
                                                        years, key components of the system in fact
emergence and rapid deepening of the financial
                                                        showed significant resilience through the past 18
crisis, acting in combination. No one or two on
                                                        months.
their own would have caused the damage that has
                                                            It also is important to remain sharply focused
occurred.
                                                        on the precise nature of the vulnerability that
    The global financial services system has
                                                        a measure is intended to address. For example,
become highly interconnected in a rich variety of
                                                        requiring a product to be largely cleared by a
ways. These include a dense and complex infra-
                                                        CCP has a different purpose and will achieve
structure for entering into and processing trans-
                                                        very different outcomes from a requirement
actions and for handling assets, a significantly
                                                        that it be exchange traded, yet the two issues of
enhanced ability to parse and transfer risk around
                                                        central clearing and exchange trading have often
the system, the enormous number and complex
                                                        been conflated and confused in the course of the
configuration of direct and indirect connections
                                                        debate. It is important to keep remedies focused
between market participants, the emergence
                                                        on the ills they are meant to cure.
of correlated exposures to risks not previously
understood, and a system-wide increase in speed
of change of asset values.                              5.2. MARKET INFRASTRUCTURE
    Such interconnectedness brings many benefits         Robust market infrastructure is as important
to the global economy and thus to welfare across        as a strengthened regulatory and supervisory
the world. However, it also is clear that such inter-   system. Important global wholesale markets and
connectedness carries significant risks and that         their supporting infrastructures have stood the
these risks have been neither fully understood          test of this crisis. OTC market infrastructure and
nor well managed in the period leading up to the        payment, clearing, and settlement systems have
financial crisis.                                        on the whole demonstrated good robustness
    The IIF regards it as important that measures       and largely normal operation throughout the
be put into place that will retain the benefits of an    crisis. The default of Lehman Brothers, despite its
interconnected and sophisticated global financial        wider impact, was handled without untoward or
system while reducing the risks to acceptable           unpredictable impact on clearing and settlement
levels.                                                 systems, and settlement of related derivatives
    It is important to be clear about precisely         transactions generally functioned as intended.
which parts of the system have shown vulner-                 Many wholesale products, CDS included,
abilities, or may be prone to doing so, and which       cannot be blamed as main drivers of the crisis per



                                                             Institute of International Finance • July 2009   ■   65
se. However, they did play a contributory role, in    2005, the industry, through the Operations
particular as a means of loss transmission and        Management Group, has been closely engaged
through heightening of uncertainty concerning         with supervisors in a range of initiatives to
the potential damage to credit quality of market      improve risk management, processing, trans-
participants. In certain markets, the absence of      parency, and the systems and procedures for
transparency contributed to the expansion of          carrying on OTC derivatives business. Over the
opaque counterparty exposures across the system.      recent period, this effort has continued at an
Significant enhancements can be achieved in            increased pace.
order to strengthen both market efficiency and              The industry and infrastructure operators, in
financial stability.                                   line with agreements with regulators, have collec-
     In addition, it is clear that where market       tively begun the process of centralized clearing
participants engaged in significant levels of          of CDS trades. Progress is continuing rapidly in
activity in respect to the products for which they    both the United States and Europe to broaden
had developed neither sufficient understanding         and deepen this process. The IIF notes that most
nor appropriate risk management ability, losses       CDS contracts are already recorded in a trade
were likely to occur.                                 repository, Depository Trust and Clearing Corpo-
     Other types of infrastructure developments       ration’s (DTCC’s) Trade Information Warehouse,
also will improve the overall resilience of the       and that efforts are reaching completion to extend
system. Certain of these are now being debated        this repository to those contracts not yet so
in the official sector but will make a significant      recorded.
difference in the medium term. An example                  The OTC interest rate swap market already
is expanding and making more consistent               benefits from a relatively high level of centralized
depositors’ expectations from deposit guarantee       clearing. There are plans to expand this further in
schemes, which will at the same time clarify          terms of membership, product, and participation
depositors’ risks, the risks of national systems,     of the buy-side community. In the equity deriva-
and supervisors’ expectations, thereby increasing     tives markets, 50% of notional trade is already
market clarity as the current extraordinary           cleared via exchanges and their associated clearing
measures are withdrawn.                               houses.
     Similarly, large-exposure regulation will make        The global FX market is one of the most
a difference to the resilience of the interbank       liquid, transparent markets in the world, with
market controlling interdependencies. Also            a daily turnover of over $3 trillion. Continuous
important to control interdependencies is the         linked settlement (CLS) ensures payment versus
development of CCPs for many OTC products, as         payment settlement in central bank funds. Under
discussed further in this section. Finally, the IIF   this system, the Lehman Brothers’ default was
is convening an infrastructure group to look at       handled smoothly, with few FX deals where
additional ways to improve resilience and better      Lehman was a counterparty being rescinded.
manage interconnectedness, including in cash          However, the possible role for a CCP backed up
and securities settlement systems.                    by a default fund should be considered. A CCP
                                                      solution could cover the replacement risk on
Progress Made                                         forward contracts, currently not covered by CLS.
                                                      It is important, however, in general, to avoid
Major progress has been made and continues
                                                      unintended consequences in areas where the
to be made in improving the operation of the
                                                      market has been shown to be working well.
OTC derivatives market, including CDS. Since



66   ■   Restoring Confidence, Creating Resilience
    In June of this year, members of the industry
entered into a number of further commitments           Commitment XX: In line with the
concerning the operation of these markets.             commitments already made by industry
This included a commitment in respect of all           participants, and reiterated in the industry
trades that are not cleared through a CCP to           letter of June 2, 2009, to the President of
universal recording of CDS trades, interest rate       the Federal Reserve Bank of New York,
derivatives trades, and OTC equity derivatives         and building on ongoing progress, industry
trades in a trade repository to be achieved over       is committed to CCP clearing of eligible
identified timescales. The IIF fully supports this      standardized CDS contracts and OTC
commitment.                                            transactions.
                                                       Commitment XXI: In line with the continuing
Standardization
                                                       work of the International Swaps and Derivatives
As stated, robust centralized clearing of trades       Association (ISDA), standardization of CDS
can reduce significantly systemic risks and should      and other OTC contracts should be pursued to
apply to eligible standardized OTC derivative          an appropriate degree.
products.
                                                       Recommendation 34: It is important,
     At the same time, it is important to note
                                                       however, that end-users of CDS and other
that bespoke OTC derivatives are vital for the
                                                       OTC contracts remain able to effectively
risk management and hedging needs of the real
                                                       hedge against specific situations. Accordingly,
economy. A move to fully standardized products
                                                       standardization should not be pursued to
would come at the cost of much less-effective
                                                       the extent that it eliminates the flexibility
risk hedging. Clients would be prevented from
                                                       achievable by the continuing availability of
utilizing hedge accounting techniques, resulting
                                                       bespoke transactions.
in increased earnings volatility and potentially
increased risks. Striking the right balance is         Recommendation 35: Authorities’
crucial in order to preserve the significant benefits    intervention in the CDS and OTC markets
bespoke OTC derivative products offer to the real      should be strongly coordinated internationally.
economy.                                               The market is international, and the
     The market for CDS and other OTC                  establishment of artificial boundaries should be
derivative contracts is international. Its interna-    avoided.
tional nature provided many benefits in terms
of both the depth of markets and the ability to
hedge risks. Authorities should ensure that their
                                                      Managing Risks of Increased Use of Central
initiatives are coordinated internationally so as
                                                      Counterparties
not to introduce distortions. They also should
avoid artificially fragmenting markets so that they    It is of great importance that central counter-
become less effective and efficient and, ultimately,   parties be operated under robust risk manage-
less resilient. The industry should ensure            ment frameworks. Systemic risk will not be
that standardization efforts are coordinated          reduced and may, indeed, increase if poorly set
internationally.                                      up clearinghouses are allowed to proliferate and
                                                      risk management standards allowed to erode. It is
                                                      important that risks not be increased by requiring
                                                      clearinghouses to deal with contracts that do not
                                                      meet their systems, liquidity, or other general
                                                      requirements.

                                                           Institute of International Finance • July 2009   ■   67
    Changes to risk management standards to             note should be taken of the confidential nature
allow lower margin levels should be monitored           of transactions between buyer and seller and the
carefully. Furthermore, clearinghouses should           likely detrimental effect on liquidity provision
not be allowed to offer new products or develop         before considering publication of information
materially increased flows without having                regarding individual transactions (trade
developed sufficiently robust risk management            reporting) to a wider audience.
methodologies. Price competition is healthy but             A variety of pre-trade price discovery mecha-
must not be allowed to lead to reduced standards.       nisms for OTC markets already exist, with dealers
The process for introduction of new products            providing price information for flow products
should be overseen carefully by the appropriate         to clients during trading hours, including live
supervisors.                                            posting of dealable prices. The industry will
                                                        continue to support the provision of such services
  Recommendation 36: Systemically relevant              going forward, with increased pricing availability
  infrastructure providers should have access to        via electronic systems and greater aggregation of
  central banks’ emergency liquidity provision.         market prices across dealers via electronic multi-
                                                        dealer trading platforms and making use of data
                                                        consolidators such as Markit or other providers.
                                                        Availability of market prices is therefore not
Enhancing Transparency, Disclosure, and
                                                        dependent on a shift of all OTC trading business
Price Discovery Mechanisms
                                                        to an established exchange.
Transparency is key for robust, smoothly
functioning markets providing reliable price             Commitment XXII: In line with the industry
discovery mechanisms. The IIF fully supports             letter of June 2, 2009 to the President of the
increased market transparency and disclosure in          Federal Reserve Bank of New York, to the
OTC derivatives through widespread transaction           extent that CDS contracts, OTC interest rate
reporting via regulated transaction repositories         derivative trades, and OTC equity derivative
to the relevant regulatory authorities. This             trades are not subject to CCP clearing, they
transparency will assist in regulatory oversight         will be recorded in a trade repository to ensure
to prevent market abuse and manage concen-               appropriate transparency of the market.
tration risk.
    Transaction reporting already is well under
way in CDS via DTCC’s Trade Information
                                                        Enhancing Other Post-Trade Infrastructure
Warehouse. The industry is committed to
providing transaction reporting to a trade              The IIF supports the views expressed by ISDA
repository of all credit derivative trades that are     in its response to the UK FSA’s Turner Review
not subject to CCP clearing.                            concerning collateral management in the context
    The IIF fully supports the continuing strong        of OTC derivative transactions. Considerable
progress toward enhanced levels of transaction          progress has been made in this area, including
reporting for other derivative transactions as          with respect to portfolio reconciliations, metrics
agreed in the industry letter of June 2, 2009, to the   on position and market value breaks, and
President of the Federal Reserve Bank of                mechanics for dispute reconciliation. We welcome
New York.                                               and support the objective of developing a
    As pointed out in the International Swaps           “best practices” document to be published by
and Derivatives Association (ISDA) response             June 2010.
to the Turner Review of June 18, 2009, however,

68   ■   Restoring Confidence, Creating Resilience
Enhancing Payment Infrastructure                        establishing a work program to look further into
                                                        infrastructure aspects of this issue. The Institute
As noted before, the existing payment infrastruc-
                                                        looks forward to engaging with the official sector
tures operated successfully, including around the
                                                        as the work proceeds.
failure of Lehman Brothers. Volumes and values
processed remained close to normal, and despite
heightened risk management measures, no undue           5.3. RATING AGENCIES
frictions or delays occurred.                           The Market Best Practices Report sets out a
     This resilience is largely due to the fact that    number of recommendations and principles
the operation of payment systems is underpinned         regarding both the oversight of rating agencies;
by a relatively small group of direct participants      their own risk management and quality
with exceptionally high-quality risk management         assurance; and how banks, other financial firms,
systems and processes and the willingness to            and investors should approach the use of their
provide the necessary liquidity even in periods of      ratings.
severe stress.                                               The IIF believes that the provision of a
     Key principles are sound intraday limits,          reliable mode of communicating issues of credit
their monitoring and management on a global             quality in a manner that is meaningful between
or regional basis with near-time adjustments,           market participants remains a matter of central
and globally aligned cut-off times (COT), as            importance and presents a difficult challenge for
well as extensions of payment infrastructures           the future.
between the central banks and system providers               The IIF welcomes and broadly supports the
in order to allow payment processing without            proposals for the oversight of rating agencies
frictions throughout and across regions. It will        developed by IOSCO and the EU, among
be important to ensure that these principles are        others. However, we note that in this area there
given ongoing robust effect.                            has not to date been a strong commitment to
     An area that displayed vulnerability and acted     international coordination by all parties. This
as an amplification mechanism was the interbank          lack of commitment carries a continuing risk of
funding market. A sudden and widespread loss of         achieving sub-optimal outcomes.
market confidence contributed to a chain reaction             While welcoming in general terms the devel-
involving banks, money market funds, and other          opment of these new approaches to the oversight
financial-sector participants in a difficult-to-          of rating agencies, the Institute contends that,
arrest spiral of fear and withdrawal. As the market     despite the good work done by IOSCO and
contracted, prudent risk management on the part         others, there should be a special role for the
of individual firms, guarding liquidity in case of       Basel Committee in setting high-level standards
need or in case of their own funding difficulties,       for ratings agencies recognized for bank capital
contributed to a seizing up of the market at all        purposes. In particular, we believe that the Basel
but the shortest maturities.                            Committee and bank supervisors should set
     It is therefore desirable to consider the          additional standards for the quality of processes
operation of the interbank markets and whether          of model validation and monitoring in rating
techniques may be developed to render them              agencies. Amplifying the discussion in the Market
more resilient to this type of chain reaction effect.   Best Practices Report, the IIF has suggested to
     The IIF’s published work on liquidity,             the Basel Committee that it develop further
including a major report in 2007 and the                standards for the quality of processes of model
Market Best Practices Report of 2008, addressed         validation and monitoring in rating agencies, and
the liquidity-specific question. Now the IIF is          has proposed independent verification of rating


                                                             Institute of International Finance • July 2009   ■   69
agency processes of model validation, governance,    securitization markets and place them on a
and monitoring, perhaps to be implemented by         sound footing for the future. The IIF strongly
a self-regulatory organization or independent        supports the efforts being made in that direction,
international review body.                           in particular the Global Joint Initiative to Restore
                                                     Confidence in the Securitization Markets of the
 Recommendation 37: The Basel Committee              American, European, and Australian Securiti-
 should develop further standards for                sation Forums and the Securities Industry and
 model validation and monitoring in rating           Financial Markets Association.26
 agencies, especially for structured products.           Closely related to issues of improving the
 There should be independent verification of          transparency and viability of securitization is the
 rating agency processes of model validation,        question of transparency of firms’ off-balance
 governance, and monitoring by means of a self-      sheet exposures. The Institute and other associa-
 regulatory organization or a new independent        tions have worked with the Basel Committee on
 international review body.                          developing new Pillar 3 guidelines on off-balance
                                                     sheet exposures, and on propagating under-
                                                     standing of the new disclosures in the market.
                                                         Among the measures that have been
5.4. TRANSPARENCY                                    developed by the industry are the European
The 2008 Market Best Practices Report also           Securitisation Forum’s RMBS Issuer Principles
identified increased transparency as key to           for Transparency and Disclosure,27 a set of recom-
both the restoration of confidence and the            mendations targeted at issuers of European
maintenance of stability for the future. Achieving   residential mortgage-backed securities (RMBS).
optimal levels of effective transparency remain      The American Securitization Forum has
central to both a stable and effective market        established Project RESTART,28 which seeks to
infrastructure and to mitigating the risks of a      reduce the opacity in securitization markets by
highly interconnected system while retaining the     developing detailed recommendations for greater
benefits.                                             transparency, disclosure, and due diligence. By
    We have discussed above the ongoing progress     making data more accessible, such efforts will
that is being made in achieving increased trans-     help investors distinguish poorly underwritten
parency in respect of OTC derivative markets,        loans from higher quality pools and create greater
including CDS.                                       market discipline and more accurate valuations.
    Another crucial area for the development             Taken together, these developments
of enhanced transparency is the securitization       represent significant advances ensuring that,
markets. As discussed in Sub-section 3.1, securi-    both pre-issuance and post-issuance, investors
tization, at least in its less-complex forms, has    and supervisors are able to obtain meaningful,
been essential to the provision of credit of many    comparable, and effective information to
important types such as automobile finance,           underpin robust risk assessment, measurement,
student loans, credit cards, and the familiar        and management in respect of securitized
types of mortgages. However, the absence of          products.
transparency in respect of certain types of struc-   26 See Restoring Confidence in the Securitization
tured products lay at the heart of the crisis. The   Markets, December 3, 2008, and related publications.
industry is fully committed to transformation        27 December 2008.

of this situation in order to restore important      28 See www.americansecuritization.com/restart.




70   ■   Restoring Confidence, Creating Resilience
     There are, of course, also important
regulatory initiatives in this area. These include   Recommendation 38: The industry and the
IOSCO’s Consultation Report on Unregulated           official sector should continue to work together
Financial Markets and Products.29 The industry       to build on the new foundations already
is closely engaged with the official sector to        developed to ensure high levels of transparency
optimize the results of such efforts.                for securitization products and markets so
                                                     that securitization can continue to play its
                                                     important role in providing finance for key
29   May 2009.                                       asset classes.




                                                        Institute of International Finance • July 2009   ■   71
 SECTION 6

Resisting Fragmentation of International Markets




S
     ection 1 sets out the benefits of an integrat-     standing commitment to greater financial services
     ed international market in financial services      integration in a single European market.
     and the importance of enhanced coordi-
nation between authorities in the regulation of        Regulatory Self-Sufficiency Measures
those markets.
                                                       Proposals that are grounded in national
                                                       regulatory authorities’ seeking to limit the
6.1. FRAGMENTING MEASURES                              damage to national stakeholders in the event of a
As discussed there, recent months have seen            firm or market failure by requiring local market
considerable levels of coordination led by the         self-sufficiency have a strong appeal if looked at
G-20 and reflected in the enhanced mandate              from a national perspective only; however, they
of the FSB and the heavy work programs of              risk undermining the resilience and effectiveness
organizations such as the Basel Committee and          of the global system.
IOSCO. However, despite this progress, including            A leading example can be found in the UK
the achievement of important agreements at the         FSA’s proposals for a new liquidity framework,
level of principle by the G-20, other developments     including a so-called self-sufficiency requirement
have been much less positive and have given rise       that UK subsidiaries and branches of non-UK
to significant concern.                                 groups meet liquidity requirements on a stand-
                                                       alone basis (see Section 3).
General Home Bias Measures                                  Similar ring-fencing or self-sufficiency
                                                       approaches are also beginning to be seen
Many governmental actions have sought to               emerging in other countries. There is no doubt
ensure that the benefits of fiscal support accrue to     that if such an approach is formally adopted
each domestic economy, in particular making the        by a large jurisdiction significant in the field of
receipt of government support subject to explicit      financial services it will rapidly be followed by
or implicit requirements to support domestic           others both as a logical conclusion as to their own
clients.                                               defensive needs and perhaps in retaliatory mode.
    Moreover, even actions designed to promote
competition have lent themselves to the de facto       Regulatory Non-coordination
reinforcement of home bias. The European
Commission’s responses to review of state aid to       In recent months there have been a number
specific businesses tend to require focus on “core      of examples of national or regional non-
business,” which may lead to retreat to home           coordination in the development of new regula-
territory, to the detriment in particular of Eastern   tory standards. This is doubly regrettable, as there
Europe. This approach is at odds with the long-        has never before been so much consensus as to



                                                            Institute of International Finance • July 2009   ■   73
the need for regulatory reform and such strong         Lessened Resilience
momentum to achieve reform in a coordinated
                                                       The adoption of a ring-fencing approach, while
manner. Failures of coordination have incurred in
                                                       it may give additional immediate comfort to any
respect of proposals for securitization reform, for
                                                       given jurisdiction, is likely to render the overall
the oversight of rating agencies and hedge funds,
                                                       system less resilient, both in terms of groups’
for credit derivatives markets, for the control of
                                                       ability to marshal resources to meet large needs
short-selling, and for the regulation of liquidity
                                                       and in terms of their ability to respond to crises.
risk management.
                                                            The direct costs associated with a widely
                                                       adopted ring-fencing approach will be neither
Extraterritoriality
                                                       modest nor moderate—nor fully predictable until
In addition, the U.S. Treasury’s Financial             the full scope of fragmentation can be appre-
Regulatory Reform proposals30 to extend criteria       ciated, by which time much will be lost.
for identifying Tier 1 financial holding companies           As compared with a top-down perspective
(FHCs) to foreign firms—including considering           whereby the prudential situation of a group is
“applying the criteria to the worldwide opera-         considered as a whole, the cost of a bottom-up,
tions of the foreign firm”—raise concerns as            jurisdiction-by-jurisdiction approach adopted
to multiple systemic stability regimes with            across the full gamut of regulatory requirements
significant overlap, with additional complexity         is likely to be very substantial.
created by extraterritoriality in lieu of interna-
tional cooperation.                                    Danger of Ill-Considered Cumulative Effects
                                                       There is a real risk that the overall outcome of
6.2. A CAUSE FOR REAL CONCERN                          current national responses to the crisis will be
However understandable some of these measures          a highly fragmented, very inefficient system
may be, viewed from the perspective of individual      wherein the general levels of capital, liquidity,
jurisdictions and given the concern to protect         and other prudential requirements are raised,
domestic taxpayers, their negative global conse-       based on decisions of the international regulatory
quences are significant, and the net result is a        standard-setters, and in addition self-sufficiency
negative-sum outcome.                                  requirements are imposed, based on bottom-up,
     It seems clear that self-sufficiency approaches,   uncoordinated actions by individual jurisdictions.
such as that proposed by the UK FSA in respect of      It is essential that such an outcome be avoided.
liquidity management, will not be limited to a few          Paradoxically, the many changes in regulation,
jurisdictions. Rather, once adopted by one major       supervision, governance, and internal risk
jurisdiction, a logical consequence will be that       management that are already well started should
such measures will be adopted by many if not all       make it possible for greater, not less, reliance
jurisdictions.                                         on home supervisors. If well designed, these
     It is difficult to conceive of an enhanced         measures will succeed in producing a more
global economy delivering strong sustainable           resilient system. Failure to take this into account
growth across the world on the basis of financial       in local responses will likely undermine the
markets that have become substantially more            benefit of all that is being done.
inward looking and forced into a nationally                 Finally, an international approach that
self-sufficient mold in the way they are conceived,     tolerates fragmentation and does not calculate the
regulated, and run.                                    cumulative effects of international and national
30                                                     measures would represent a dramatic change of
  Financial Regulatory Reform: A New Foundation,
June 2009.
                                                       the general development of the global economy

74   ■   Restoring Confidence, Creating Resilience
since 1945. There is a real risk that, over the       IMF, particularly in the context of its Article IV
coming years, inward-looking, control-driven          surveillance and through a consistent, objective,
regulation could replace the drive toward the         and even-handed Financial Sector Assessment
realization of mutual benefits. Despite the clear      Program (FSAP) process.
intent of the G-20 and FSB to the contrary, there
is a danger of a loss of global integration and        Recommendation 39: The FSB should,
cooperation, as happened between 1914 and              together with the IMF, make addressing
1945. Resolute steps should be taken to avoid this.    fragmentation of the international financial
                                                       market a permanent objective. This should
6.3. FIGHTING FRAGMENTATION                            complement the FSB’s important task
                                                       of ensuring enhanced cooperation and
Authorities that adopt inward-looking measures         coordination among authorities.
face genuine dilemmas resulting not only from
political pressures arising from the cost of the
crisis but also from the fact that firms remain
“national in death.” Moreover, the difficulties        Substantive Measures and Steps to Address
faced result from deep coordination problems          the Confidence Deficit
arising from the stage of development of inter-       Ultimately, what drives a jurisdiction-focused,
national cooperation, wherein much remains            self-sufficiency approach is failure of confidence
on a state-based footing. Such problems cannot        in other authorities and in the global market.
be fully resolved simply by doing more of what        That is, authorities consider that in the event of
has been done before, although a return to the        the failure or near-failure of a cross-border group,
growing cooperation seen until recently could         stakeholders in the jurisdiction—depositors,
continue incremental progress. Fresh ideas and        creditors, the financial system, and taxpayers—
renewed political determination are necessary.        will suffer disproportionately as compared with
                                                      stakeholders in other jurisdictions.
Bodies Taking up the International Challenge               It is necessary to take significant new actions
The FSB’s new mandate includes the responsi-          to address this issue. To that end, several recom-
bility to promote coordination and to advise on       mendations of this Report relate to the estab-
how countries perform in meeting regulatory           lishment of significantly revised arrangements for
standards. Members agree, inter alia, to maintain     dealing with cross-border crisis management and
the openness of the financial sector, to adhere to     financial firm resolution. These issues are dealt
agreed international standards, and to undergo        with in detail in Section 7.
peer review.
     The IIF proposes that a further task of the      A New Foundation for International
FSB should be to monitor regulation or other          Cooperation
official-sector actions that have a materially         Experience in many areas of international
fragmenting effect from the global perspective,       coordination and cooperation has been that
to raise those matters for discussion, and to issue   a point is reached at which it is necessary to
public reports including alternative suggested        establish mutual commitments on objectives and
approaches to address the problems motivating         principles in order to overcome the coordination
national authorities. Fragmentation also could be     problems that hinder enhanced mutual reliance.
added to the FSB’s peer-review program.               In respect of international markets in financial
     In addition, countering financial fragmen-        services, the world is at such a juncture now.
tation can be furthered by the activities of the

                                                           Institute of International Finance • July 2009   ■   75
Thus, the time is right for an inter-governmental          An accord would make a significant
accord on financial markets and financial services       contribution to the restoration of confidence in
among the G-20.                                        financial markets. By expressing agreement on a
    Such an accord at this stage probably could        range of topics currently viewed, perhaps incor-
not be a binding international treaty but could        rectly, as difficult or divisive, it could rebuild and
articulate, at a sufficient level of granularity to     reinforce mutual confidence across jurisdictions.
create confidence in reliable execution by major            Also, it would provide a clear framework
countries, the objectives and aims, principles, and    within which national authorities could approach
parameters agreed to be essential to the financial      their international responsibilities. For example, it
system of each jurisdiction as well as of the global   could provide the necessary basis for meaningful
financial system. This would provide a firm basis        progress on cross-border crisis management, the
for enhanced mutual confidence and trust.               need for which is discussed in Section 7.
    Such an accord could provide the impetus to
significantly enhanced cross-border cooperation           Recommendation 40: The point has been
including renewed progress on mutual                     reached where international cooperation
recognition.                                             and coordination should be put on a firmer
    It would provide a basis of clear expectations       footing. We recommend the development of a
for authorities’ dealings with each other on cross-      non-binding inter-governmental accord on
border financial services issues.                         financial markets and financial services.




76   ■   Restoring Confidence, Creating Resilience
     SECTION 7

Cross-Border Crisis Management and Financial Firm
Resolution Regimes


7.1. A MISSING LINCHPIN                                 include contingency planning for cross-border
                                                        crisis management. We also welcome the estab-
Clear arrangements for the effective management
                                                        lishment by the FSB of a Cross-Border Crisis
of crises affecting large, cross-border institutions
                                                        Management Working Group.
will be critical to restored confidence in and
                                                            The FSB should develop a comprehensive
resilience of a strongly functioning international
                                                        framework of planning and preparation for
market in financial services. As the Group of
                                                        crises and their management. It should put in
Thirty report stated, “The most pressing and
                                                        place a strong regime for the governance of
complex of those [needed] enhancements relate
                                                        crisis management. Building on its position as
to making crisis management coordination more
                                                        a neutral but deeply informed participant, the
effective and operational by agreed protocols.”31
                                                        FSB should develop a coordination, advisory, and
     The most effective forms of cooperation
                                                        non-binding mediation role in the preparation
between authorities in the ongoing supervision
                                                        of crisis management arrangements in respect to
of cross-border entities will be difficult to achieve
                                                        individual groups to help ensure optimal coordi-
without an effective and fair mechanism for
                                                        nation between the authorities directly involved
managing and resolving crisis events affecting
                                                        in a particular crisis.
individual institution.
     A host supervisor is less likely to trust the
judgment of a home supervisor if it believes            7.3. GOVERNING ARRANGEMENTS
that in a crisis the home supervisor will be led to          IN CROSS-BORDER
make decisions prejudicial to the interests of the           COOPERATION
host jurisdiction. Equally, it is more difficult for a
                                                        The FSB (then the Financial Stability Forum)
home supervisor to rely on the decisions of a host
                                                        published in April Principles for Cross-border
supervisor if the potential to “free ride” remains
                                                        Cooperation on Crisis Management. The Principles
open to the latter in a time of crisis.
                                                        include joint work between home and host
                                                        supervisors to consider barriers to crisis coordi-
7.2. INSTITUTIONAL CONTEXT                              nation and the development of common crisis
A primary challenge for the FSB is to make              management tools, information sharing, and
significant and rapid progress in putting in             annual meetings that also include central banks
place effective crisis management and resolution        and finance ministries relevant to the group.
arrangements for international institutions. We         Authorities are to strive to find internationally
welcome that its mandate has been expanded to           coordinated solutions that take account of the
                                                        impact of the crisis on the financial systems and
31Financial Reform—A Framework for Financial            real economies of other countries.
Stability, January 2009.


                                                             Institute of International Finance • July 2009   ■   77
     However, as is clear from the high-level nature
of the principles and the aspirational language of        Recommendation 41: The FSB, as a priority,
important parts of the document, there remains            should develop a convention on cross-border
a lot to be done to develop a robust and reliable         crisis management. The FSB should develop a
framework for cross-border crisis management.             coordination and non-binding mediation role
     The FSB should as a matter of high priority          in preparation of arrangements for cross-border
enhance its principles to establish an FSB                crisis management concerning individual
convention on cross-border crisis management              groups.
to which all FSB members would adhere. This
could ultimately be included in an international
financial services accord as discussed in Section 6.
It should include:                                      7.4. SIMULATION EXERCISES
                                                        Significant enhancement of cross-border crisis
     A commitment to coordinated responses to           simulation exercises involving participants and
     crises and a clear statement of the objectives     authorities will be essential to building credibility
     of such coordination;                              for crisis management. The IIF noted the benefits
     Specification of the normal-time activities         of such simulation exercises in the 2006 Proposal
     to be carried out by “cross-border stability       for Strategic Dialogue on Effective Regulation, and
     groups” to be established in respect of each       it is now all the more apparent that such exercises,
     firm and the responsibilities (and rights)          based on a strong commitment of all concerned,
     of the home and host authorities, working          would be a significant way in which crisis
     closely with the colleges of supervisors for       management could be improved.
     such groups;32                                          Not only can such exercises make a significant
     A detailed list of data and information to be      contribution to the performance of participants
     maintained and shared during normal times;         in crisis situations and bring to light barriers
     Establishment of requirements for normal-          to the achievement of optimal coordinated
     time preparations for crisis events including,     outcomes, they also can foster the spirit of
     most importantly, regular crisis simulation        cooperation and mutual understanding necessary
     exercises (see further below); and                 to achieve those outcomes.
     Detailed rules and guidelines for cooperative
     handling of a crisis situation, including            Recommendation 42: Cross-border crisis
     early intervention and the specification of           simulation exercises should be carried out on a
     cooperation mechanisms.                              regular basis and with strong participation by
                                                          relevant authorities and market participants.
    The Institute is encouraged that the
recently established FSB Cross-Border Crisis
Management Working Group will be developing
a framework to implement the FSB’s principles
and recommend that its work include the aspects
outlined above.

32 Building on the relevant college, a cross-border
stability group would also include representatives of
relevant finance ministries and central banks.


78   ■   Restoring Confidence, Creating Resilience
7.5. BURDEN SHARING                                     analysis, and decision being also responsible for
                                                        an appropriately larger share of the costs.
A Coordination Problem
                                                            It would be necessary that the commitment
In the absence of a reliable mechanism for the          to burden sharing in accordance with agreed
allocation of the costs of financial interventions       criteria be enshrined in a high-level, binding,
to support or resolve troubled cross-border             international agreement. This should be agreed,
banks, the decision whether or not to intervene         for example, under the auspices of the G-20 and
will fall on the home authorities, and they will        administered by the FSB and could be developed
have little incentive to take into account the costs    in the context of the convention discussed in
to other jurisdictions in determining their course      Sub-section 7.3.
of action.                                                  The agreements as to the sharing of burdens
    However good cooperation among super-               in respect of individual firms should be reached
visors is during normal times, the fact that            through the FSB. It would be necessary to embed
support or resolution decisions will be taken on        rules of decision-making concerning whether to
a home-country basis, generally by authorities          intervene with financial support.
other than the supervisor, will always color
the ability of supervisors to rely on each other.       Constructive Ambiguity and Clarity
Without a more robust international regime, the
                                                        It often is said that agreements on burden sharing
logical conclusions from this can lead national
                                                        are not possible without undermining the
supervisors to self-sufficiency or ring-fencing
                                                        “constructive ambiguity” concerning government
precautions, as is emerging today. It is essential to
                                                        intervention that is necessary to avoid undue
break this cycle.
                                                        levels of moral hazard. This concern, although
                                                        certainly a legitimate subject for debate, is not
Fiscal Burden Sharing
                                                        justified. As the de Larosière Group pointed out,
It will be necessary to envisage the means for          there is an important distinction to be made
governments to intervene collectively to resolve        between agreement as to how burdens will be
or recapitalize firms. To do this effectively, it will   shared should it prove necessary to intervene
be necessary to have binding agreement on how           financially to rescue a financial institution and a
the burden of fiscal interventions will be allocated     decision that such an intervention should actually
among involved governments. It will be necessary        be carried out.
to develop criteria for the allocation of fiscal
burdens of government interventions having              A Common Fund
regard to the extent to which each country will
                                                        The resolution of crises affecting individual
benefit relative to others in the achievement of
                                                        institutions frequently involves costs, in particular
stability and consumer protection objectives.
                                                        in ensuring that depositors and other protected
    The only way is for countries to work urgently
                                                        parties do not suffer loss. In the context of the
together, under the auspices of the FSB, to
                                                        failure of a large and interconnected cross-border
develop criteria. A good starting point for this is
                                                        group, this can, depending on the manner in
the criteria identified by the de Larosière Group:
                                                        which the group fails, give rise to a dispropor-
the deposits of the institution, its assets, its
                                                        tionate burden on the fiscal authorities and
revenue flows, its share of payment system flows,
                                                        deposit or policyholder protection scheme of one
and the division of supervisory responsibility—
                                                        or other jurisdiction.
the country responsible for supervisory work,



                                                             Institute of International Finance • July 2009   ■   79
    Consideration could be given to the estab-              2. Transparent—Creditors and counter-
lishment of a common fund which, being made                    parties of the institution concerned
available in conjunction with the agreed burden-               should be clear as to how the intervention
sharing criteria, could be used to facilitate orderly          affects their rights.
resolution or disposition of the failing cross-             3. In line with market practices—Intervention
border group and equitable depositor or policy-                should not violate clearing, settlement,
holder protection. However, neither the political              payment finality, netting, set-off, or
nor operational challenges associated with such a              collateral systems and procedures.
fund should be minimized.

     Recommendation 43: Under the auspices              Overriding Public-Good Objectives
     of the G-20 and subject to coordination by
                                                        When a government intervenes in the insolvency
     the FSB, criteria of burden sharing between
                                                        of a financial firm, it is by definition doing so
     jurisdictions in the event of the need for
                                                        in order to avoid damage to society and the
     financial intervention should be agreed among
                                                        economy, that is, it is pursuing the public good
     the major countries.
                                                        of systemic stability—very often protection of
                                                        the payments system—or consumer protection.
                                                        The effective achievement of this public good
7.6. CROSS-BORDER BANK AND                              should—to the extent necessary—override the
     FINANCIAL FIRM RESOLUTION                          ordinary principles of bankruptcy. Thus, all
                                                        authorities involved should be empowered and
     REGIMES
                                                        required to act so as to promote that objective.
When an international bank is in danger or fails,           Governments should not have to grant
governments should ensure that they have the            themselves ad hoc powers in such cases. The
necessary legislative, administrative, and legal        idea that government may act on an ad hoc basis
powers in place to enable themselves to conduct         depending on a particular case creates deep
such interventions in a swift and effective fashion,    uncertainty in the markets and damages the legal
in cooperation with authorities in other jurisdic-      certainty underpinning those markets.
tions. They particularly should ensure that they            Government intervention in a failing insti-
have in place all of the relevant powers and            tution should be possible at a time when the
authorities identified in the IMF/World Bank             institution is in difficulty or is in breach of its
Overview of the Legal, Institutional, and Regulatory    regulatory obligations. There should therefore
Framework for Bank Insolvency.33                        be “regulatory” as well as “solvency” grounds for
                                                        government intervention in the affairs of the
Special Regime for Bank Resolution                      relevant bank.

General Principles of Intervention                      Obligation to Pursue the
Any government intervention in a failing firm            Public-Good Objective
should be the following:                                The person or persons charged with the conduct
    1. Rapid—No significant period of                    of the rescue or disposition of a bank, where
       uncertainty should exist between the             such intervention is justified by public-interest
       announcement of intervention and the             considerations, should be placed under a positive
       intervention itself.                             obligation to pursue that objective. This should
33   IMF, April 17, 2009.

80      ■   Restoring Confidence, Creating Resilience
include the power to affect the rights of creditors     Cross-Border Issues in Bank Failure
in certain limited circumstances. Although the
                                                        Multinational banks have complex corporate
principle of equal treatment of creditors is a
                                                        structures, and in the event of the failure of
fundamental principle of insolvency law, in the
                                                        such a bank, there will not be a single court or
case of bank rescues it should, in appropriate
                                                        office holder charged with the liquidation of the
cases, give way on a well-understood basis before
                                                        group. It is in fact more than likely that an inter-
the overriding objective of reducing systemic
                                                        national bank will operate through more than
damage.
                                                        one significant subsidiary, as well as through a
     Thus, for example, an administrator, receiver,
                                                        number of less-significant subsidiaries. Therefore,
debtor-in-possession, or similar party appointed
                                                        there are likely to be several different courts seized
to control a firm in insolvency (“office holder”)
                                                        of different parts of the group restructuring.
should have defined powers to deliver securities
and make payments to close out transactions in
                                                        Facilitation of International Cooperation
order to avoid systemic disruption, even before
                                                        Is Key
the full list of creditors and assets has been
drawn up.                                               The issue therefore is how governments should
     Any such powers must, to the greatest extent       best manage the process of a failure of an interna-
possible, be constrained within the existing law.       tional bank group. The first important step would
The creation of broad discretionary powers to           be to create a situation in which office holders of
vary existing contracts would make restructuring        individual parts of the failed institution should
existing institutions easier. However, the market       be required to have regard to the situation of
uncertainty that this would create would have a         the group as a whole and should be permitted
substantial detrimental effect on every market          expressly to work with office holders of other
contract, create major blockages to innovation,         parts of the group and the management of any
and do significant damage to the markets as a            group entities that are not insolvent or the subject
whole.                                                  of proceedings in order to maximize returns
     The basis of financial markets is legal             to creditors and to minimize disruption to the
certainty and in particular the confidence of            financial markets as a whole.
counterparties that settlement finality, set-off, and        In general, national legislation does not
collateral rights will be respected in the insolvency   mandate and may not permit cooperation among
of any particular system participant. Thus, for         administrators, curators, liquidators, or other
example, in the recent failure of Lehman Brothers,      office holders appointed in different jurisdictions.
the reason why the credit derivative markets            The Institute contends that governments should
remained robust was because market partici-             explore establishing broad principles for cooper-
pants had confidence that the set-off provisions         ation in the failure of international institutions,
contained in open contracts would survive and be        permitting office holders to act collectively with
effective in the insolvency. If there had been doubt    office holders appointed in other jurisdictions
as to this point, it is likely that the impact of the   over other parts of an insolvent group.
failure on the system as a whole would have been
substantially greater than it in fact turned out        No Discrimination Based on Nationality
to be. The powers of office holders described in         or Place of Residence
this discussion should be designed to ensure such
                                                        The aim of such cooperation should be to
market-reinforcing results in future insolvencies.
                                                        maximize the position of creditors of the group as
                                                        a whole. Governments should consider explicitly
                                                        permitting national courts to approve a scheme

                                                             Institute of International Finance • July 2009   ■   81
that could result in creditors in its own juris-         establishment by treaty of an international insol-
diction being potentially worse off provided that        vency regime. But this is unlikely to be achieved
creditors of the group as a whole are better off in      in the short term.
aggregate.                                                    The most important short-term practical
     In other words, the available assets should be      steps would be for governments to engage in
used to settle claimants’ rights as fairly as possible   intense dialogue with each other about how to
without discrimination based on jurisdiction,            deal with creditors, depositors, policyholders,
subject to the usual priorities and to netting and       and other claimants in respect of the failure of a
settlement considerations as already mentioned.          cross-border institution. Such discussions might
     A similar principle should apply in respect of      be conducted in the context of the convention
depositor and policyholder protection schemes.           on cross-border crisis management suggested
Governments derive their tax revenue from                at Sub-section 7.3. Establishment of broad
their domestic taxpayers and may feel that the           principles, such as the principle of non-discrim-
first call on such revenues is the compensation           ination among creditors by nationality and the
of domestic customers of a bank. This principle          principle that office holders should be clearly
would be unobjectionable if applied consistently,        empowered and encouraged to work in concert in
because it would result in a position where each         resolving a large group, would be highly beneficial
government compensated customers in its juris-           in laying the groundwork for more orderly
diction regardless of the place of establishment of      resolutions in the future.
the bank.
     However, in the absence of a global inter-           Recommendation 44: Under the auspices of
governmental agreement it is unlikely that each           the G-20 and subject to coordination by the
government will adopt identical policies and              FSB, authorities, as a matter of priority, should
that customers in different jurisdictions will all        ensure that they have in place special regimes
be equally protected. As a result, the resolution         for bank resolution:
of such crises may be slowed by (and in extreme
                                                             They should have the power of early
cases prevented by) a suspicion of free-riding or
                                                             intervention.
unequal benefit, such as may arise from exclusive
                                                             On determination that an institution is
priorities for domestic deposit guarantee schemes
                                                             systemically significant, the winding-up of
to certain assets, to the detriment of the principle
                                                             such institution should have as a primary
of non-discrimination across jurisdictions.
                                                             objective the protection of the international
     It should be noted that this issue is in fact
                                                             financial system.
wider than just deposit protection schemes,
                                                             In order to preserve market certainty and
because it also may arise in regard to guarantees
                                                             confidence, financial markets law (for
or other sureties that governments may offer
                                                             example, concerning settlement finality, set-
during crises to depositors or other creditors of
                                                             off, and collateral rights) must be respected.
troubled institutions.
                                                             In the context of the winding-up of a cross-
                                                             border financial firm, the objective should
Desirability of an International Bank
                                                             be, subject to preserving the integrity of the
Resolution Regime
                                                             financial system, to maximize outcomes
In considering the appropriate policy response to            for creditors of the group as a whole. There
this range of issues, it is important to be realistic        should be no discrimination between
about what can be achieved. It may well be true              creditors on grounds of nationality or
that the optimal way of dealing with the failure             geographical location.
of an international banking group would be the

82   ■   Restoring Confidence, Creating Resilience
Commitments and Recommendations




  Importance of Coordination in an                Recommendation 3: A global framework for the
  International Market                            supervision and regulation of internationally
                                                  active insurance firms on a group-wide basis
  Commitment I: The IIF membership will           should be developed under the leadership of the
  dedicate the necessary resources and engage     IAIS.
  with their colleges of supervisors on a high-
  priority, fully committed basis.                Recommendation 4: Clear strategies should
                                                  be developed for the withdrawal of governments
  Recommendation 1: The FSB should                from ownership positions in financial
  proceed quickly and with continued              institutions and for ending extraordinary
  determination in taking the steps necessary     liquidity and market support measures. Such
  for the establishment and operation of          strategies should be carefully coordinated
  well-functioning colleges of supervisors        internationally to be fully effective and minimize
  for internationally active banks. Ensuring      the risk of unanticipated consequences.
  effectiveness, high-quality cooperation, and
  appropriate consistency in the operation of
  these colleges should be a high-priority task   A Shared Responsibility to
  for the FSB and supervisory authorities.        Achieve Resilience

  Recommendation 2: National authorities          Commitment II: The IIF membership will as a
  should coordinate closely in respect of the     matter of first-order priority continue the good
  wide array of regulatory proposals that are     progress to bring their risk management and
  currently under consideration, working          other business practices into alignment with the
  through the relevant international standard-    recommendations of the Market Best Practices
  setting bodies. Such coordination should go     Report.
  beyond the level of principle or direction
  and ensure consistency of specific regulation.   Commitment III: The standards set out in the
  There should be timely and consistent global    Market Best Practices Report have become
  implementation of Basel II, appropriately       a benchmark for large, internationally active
  modified. Coordination becomes increasingly      firms. The industry welcomes the use of this and
  important given emerging fragmentation.         other reports, such as the Senior Supervisors
                                                  Group Report of March 6, 2008, in the
                                                  supervisory assessment of the quality of risk
                                                  management of such firms.


                                                       Institute of International Finance • July 2009   ■   83
     Commitment IV: The industry is committed          Recommendation 7: It is essential that
     to continue to implement reforms in               regulation be effective while ensuring that
     compensation practices so as to align             markets remain as efficient as possible. The
     these practices with the IIF Principles and       principles of effective regulation should be
     recommended leading practices, as well as         followed, including:
     with the FSB Principles. In this regard,
     the IIF intends to monitor developments in             Clearly identified objectives;
     industry practices and to provide an informal          Clear understanding of impacts, both
     assessment in the forthcoming report of the            positive and negative (but avoiding
     IIF Steering Committee on Implementation               mechanistic or purely quantitative
     in November 2009 and to conduct a survey of            methods);
     industry practices in 2010.                            An incentives-focused methodology;
                                                            and
     Recommendation 5: Regulatory authorities               Incorporation of consultation and
     should develop appropriate supervisory                 dialogue.
     guidelines on compensation, in line with
     FSB Principles, in a timely manner so as to       Recommendation 8: There should be a
     reduce market uncertainty. The FSB should         structured, ongoing dialogue between the
     ensure that these guidelines are consistent,      FSB, the standard-setters, and the industry
     in all important respects, across jurisdictions   to support high-quality, effective, and well-
     and that a reformed regulatory environment        coordinated international regulatory reform.
     also provides for a level playing field on         This should cover all financial sectors and all
     compensation between the regulated and non-       types of regulation (prudential and conduct of
     regulated segments of the financial market.        business).

     Commitment V: The IIF membership will             Recommendation 9: Resilience depends in
     undertake the efforts and investment necessary    large part on the risk management of firms
     to promote the success of more outcomes-          and the functioning of markets. Regulation
     focused, judgment-based supervision. This         cannot do the job on its own. It is essential
     will include developing standards and norms       to restore and enhance market discipline,
     of behavior to underpin a better quality of       in particular by ensuring that creditors of
     relationship with supervisors.                    financial institutions (other than depositors
                                                       and insurance policyholders, and subject to
     Recommendation 6: Authorities should              the rules of priority in insolvency) are at risk
     continue to develop a more consistently           of appropriate loss in the event of failure.
     outcomes-focused, judgment-based approach         Reform should lever and seek to enhance the
     to regulation. The IIF recommends increasing      positive dynamic between markets operating
     the resources, expertise, and skills of           under effective discipline and more effective
     supervisors to implement macroprudential          regulation.
     oversight.




84   ■   Restoring Confidence, Creating Resilience
Achieving Resilience Through                       Recommendation 13: There should be dialogue
the Cycle With Prudential and                      between the official sector and the industry to
Accounting Standards                               develop effective approaches to the very difficult
                                                   task of evaluating the cycle and deciding when
Capital                                            to apply buffer mechanisms, on the upside or the
                                                   downside.
Commitment VI: Levels of capital in many
parts of the system were insufficient. The IIF      Commitment VIII: The IIF agrees that the
agrees that overall levels need to be increased,   quality of capital required needs to be reviewed.
within the framework of the Basel II risk-based    The IIF membership is ready to work closely
approach, as compared to pre-crisis levels. The    with the official sector to achieve an outcome
IIF membership stands ready to work with the       that reflects the lessons learned from the recent
regulatory community on objective analysis         period.
of the cumulative net impact of proposed
regulatory changes.                                Recommendation 14: Consistent international
                                                   requirements for the definition and quality of
Recommendation 10: The cumulative                  capital, in particular Tier 1 capital, should be
impact of proposed enhancements of capital         developed. They should be applied consistently
requirements and other regulatory and              on a global basis. The benefits of Tier 2 capital,
accounting changes should be fully assessed        including convertible Tier 2, should not be
prior to final decisions being made.                underestimated.

Recommendation 11: The timing of
                                                   Controlling Leverage
introduction of new requirements should be
carefully considered to ensure that they do not
                                                   Commitment IX: The IIF agrees leverage was
hinder recovery.
                                                   too high and needs to be appropriately controlled
                                                   in the future.
Commitment VII: The IIF supports measures
to counter cyclicality by building resources in
                                                   Recommendation 15: A simple leverage ratio
good times that can be drawn down in bad
                                                   runs the risk of undermining its own objectives.
times.
                                                   Any measure to contain leverage should take
                                                   account of differences in business models
Recommendation 12: Buffers, whether                and funding structures, major differences in
created by capital or reserves, should be able     risk profiles, distinct market practices and
to be drawn on when needed without adverse         characteristics, and differences in accounting
consequence.                                       standards. Leverage should be addressed as a
                                                   supervisory tool for use as part of the Pillar 2
                                                   dialogue between a firm and its supervisor.




                                                        Institute of International Finance • July 2009   ■   85
     Accounting                                          flows due to a reporting entity. Work currently
                                                         in progress to review fair-value and accrual
     Recommendation 16: There should be a                accounting for financial institutions should
     comprehensive, high-level dialogue on current       continue with urgency. It should also address,
     accounting standards in light of the crisis         as part of the comprehensive simplification of
     and the changing regulatory environment.            financial instrument reporting, existing rigidities
     This should involve all relevant parties while      in hedge accounting.
     respecting the independence of the standard-
     setting process.                                    Recommendation 21: Reporting changes in
                                                         an entity’s own credit in earnings is a source of
     Recommendation 17: Achieving overall                controversy. The debate should consider whether
     convergence in international accounting             elimination of recognition of changes in the
     standards requires active support from              reporting entity’s own credit quality in reported
     all concerned, including the industry and           earnings would provide simpler, more direct, and
     securities and prudential regulators. There         more decision-useful information to the market.
     should be a renewed commitment by all
     stakeholders to a clear plan for timely             Recommendation 22: Consistent guidance
     adoption of a single, high-quality set of           should be issued by the major standard-setters
     accounting standards.                               to allow the use of reasonable interpretation
                                                         in assessing loan losses under the incurred-
     Recommendation 18: Exceptional processes            loss model. Such guidance should be given
     should be in place to provide guidance on as        the unambiguous backing of securities
     expedited a basis as possible while allowing        regulators in order to help avoid the overly
     for rapid consultation with stakeholders in the     narrow applications that have contributed to
     event of extraordinary occurrences.                 procyclicality. The current review to consider the
                                                         reflection of a wider range of credit information
     Recommendation 19: While progress has               in standards for loan loss provisioning must be
     been made to date on valuation in less-active       given priority.
     markets, more needs to be done. Standard-
     setters should develop a common framework
     that reduces the complexity and multiplicity        Liquidity
     of existing impairment models on the basis of
     all available relevant information. This should     Commitment X: IIF members have already
     be done on a fully convergent basis, taking into    enhanced their liquidity risk management and,
     account the lessons learned from the crisis.        subject to difficult market conditions, have been
                                                         building liquidity buffers and working toward
                                                         compliance with the IIF and Basel liquidity
     Recommendation 20: Fair-value accounting            principles. In addition, they continue to manage
     has clear benefits in appropriate contexts.          their liquidity to ensure that local liquidity
     However, questions have been raised                 needs can be met. IIF Members will continue
     concerning its effects on cyclicality, and it may   the ongoing enhancement of their approach to
     not always provide the best reflection of cash       liquidity management.



86   ■   Restoring Confidence, Creating Resilience
Commitment XI: Good liquidity risk                  Recommendation 24: In determining a firm’s
management should take into account                 liquidity buffer, mechanistic approaches that do
local market needs. In addition, the IIF            not take into account the overall business model,
is committed to exploring ways in which             funding profile, and market context of the firm
firms could organize their cross-border              are likely to be counterproductive and should not
business to reduce the concerns of authorities      be adopted.
that individual jurisdictions would suffer
disproportionate loss in the event of an            Recommendation 25: Overly narrow definitions
insolvency. This should take place in the           of eligible liquid assets for liquidity buffers
context of the ongoing dialogue between large       should be avoided as a matter of proportionality
firms and the authorities concerning the             and to avoid unintended consequences. The
information necessary to plan for the orderly       definition of eligible assets should be both
exit of the firm should that prove necessary         coordinated internationally and developed in
as discussed in Section 4. Such an approach         tandem with revised (and coordinated) central
would take into account the legal structure of      bank lists of eligible collateral for ongoing
the group and differences in insolvency laws        monetary operations and (non-emergency)
across jurisdictions. The IIF stands ready to       liquidity purposes.
work with the official sector to reduce the real
dilemmas that the tensions between global
                                                    Recommendation 26: There should be
and local goals for good liquidity management
                                                    comprehensive international coordination.
present.
                                                    This includes liquidity reporting requirements,
                                                    as proliferation of detailed but inconsistent
Recommendation 23: Although the serious             requirements across jurisdictions will impose
issues raised by failures of major market           undue burdens and costs, contribute to systemic
participants need to be addressed, the              vulnerability, raise compliance risk, and
significant drag on system efficiency created by      distract from the clarity of internal reporting to
“trapped pools of liquidity” also is important      management.
and needs to be taken into account. Self-
sufficiency or stand-alone approaches to
                                                    Commitment XIII: The IIF agrees that a
liquidity regulation should be resisted by
                                                    significant component of funding should be
regulators.
                                                    comprised of stable elements, as part of well-
                                                    understood overall funding plans.
Commitment XII: It is necessary to hold
liquidity buffers against liquidity risk. This is
                                                    Recommendation 27: A strict, mandatory core-
an important part of a robust overall approach
                                                    funding ratio should not be adopted. Such an
to liquidity risk management.
                                                    approach is unlikely to reflect different degrees
                                                    of stability and would be prone to material
                                                    unintended consequences (such as an increased
                                                    volatility that would result from enhanced
                                                    competition for deposits).




                                                         Institute of International Finance • July 2009   ■   87
     Financial Stability Through                        Commitment XVII: The IIF agrees that
     Macroprudential Oversight                          the supervisory review process applied to
                                                        firms should be founded on a risk-based
     Commitment XIV: The IIF’s recently-                approach. Accordingly in determining what
     established Market Monitoring Group is             if any supervisory measures should be taken,
     committed to identifying and assessing             supervisors should incorporate analysis of the
     systemic vulnerabilities and issues emerging       nature and degree of a firm’s impact on the
     in the markets. It stands ready to discuss such    system should that firm fail. Members are
     developments with the official sector.              committed to working with supervisors to make
                                                        such an approach effective.
     Recommendation 28: Macroprudential
     analysis at the international level will need      Recommendation 30: Artificial restrictions on
     to be translated into actionable measures for      size or diversification should be avoided. Large,
     implementation. Given the G-20’s mandate           complex institutions play an important role in
     to the FSB, the FSB’s resources should be          supporting the global economy. Restrictions on
     augmented for this purpose.                        size or diversification could produce materially
                                                        distorting effects and unmanageable risk
     Commitment XV: The IIF agrees that                 patterns within the system. The industry agrees,
     authorities will require access to all relevant    however, that in addition to ensuring that such
     and material information to carry out effective    institutions meet the highest standards of risk
     financial stability oversight. The industry will    management, it is essential that they be subject
     work with regulators to identify and provide       to effective market discipline. To this end, there
     such information.                                  should be developed the infrastructural, legal,
                                                        and process reforms necessary to ensure that all
                                                        firms can exit the market in an orderly fashion
     Recommendation 29: It would be                     without causing undue trauma to the system.
     counterproductive to create a formal or
     published category of highly systemically
     relevant firms. Systemic risk does not reside       Recommendation 31: Restrictions on the
     in single entities but in the interconnectedness   business models or range of activities of firms
     of firms, markets, and players. It is a rapidly     should be avoided. While it may be appropriate
     evolving and multifaceted concept that should      to require additional capital in respect of
     be addressed using appropriately sophisticated     higher risk activities, there is no good case to
     and adaptive techniques, which avoid               prevent firms from engaging in a full range of
     distortions and moral hazard.                      financial activities in accordance with sound
                                                        and well-managed business models. Far from
                                                        being a source of vulnerability, diversified, well-
     Commitment XVI: The IIF agrees that the            managed, and profitable firms provide a source
     degree of systemic relevance of a firm may          of real resilience for the overall system.
     require more intensive supervision. Members
     are committed to working with supervisors to
     make such an approach effective.




88   ■   Restoring Confidence, Creating Resilience
Commitment XVIII: Consistent with the              Improving Market Infrastructure
principle that no firm should be designated         and Mitigating Risks of
too big to fail, large or highly interconnected    Interconnectedness
firms should examine with the authorities the
risks that their role in markets and products      Commitment XX: In line with the commitments
create, to help the authorities assess what        already made by industry participants, and
would happen in event of their failure. The        reiterated in the industry letter of June 2, 2009,
ongoing dialogue between such firms and             to the President of the Federal Reserve Bank of
their authorities should include consideration     New York, and building on ongoing progress,
of all the information necessary to plan for       industry is committed to CCP clearing of
the orderly exit of the firm should that prove      eligible standardized CDS contracts and OTC
necessary.                                         transactions.

Commitment XIX: Riskier activities should be       Commitment XXI: In line with the continuing
subject to appropriately risk-weighted capital     work of the International Swaps and Derivatives
requirements. Such capital requirements            Association (ISDA), standardization of CDS and
should be calibrated so as to reflect the risk of   other OTC contracts should be pursued to an
those activities and consideration should also     appropriate degree.
be given to relevant cost of funding issues.
                                                   Recommendation 34: It is important, however,
Recommendation 32: The FSB should                  that end-users of CDS and other OTC contracts
coordinate the engagement of supervisory           remain able to effectively hedge against specific
colleges in the implementation of the policy       situations. Accordingly, standardization should
conclusions arising from macroprudential           not be pursued to the extent that it eliminates
oversight and analysis, as well as in the          the flexibility achievable by the continuing
assessment of emerging financial stability risks.   availability of bespoke transactions.

Recommendation 33: To achieve                      Recommendation 35: Authorities’ intervention
macroprudential aims effectively and               in the CDS and OTC markets should be strongly
efficiently, a structured international dialogue    coordinated internationally. The market is
should be put in place between authorities         international, and the establishment of artificial
and firms. This should involve an industry          boundaries should be avoided.
platform, representing firms subject to FSB
colleges and the supervisors involved in those
                                                   Recommendation 36: Systemically relevant
colleges.
                                                   infrastructure providers should have access to
                                                   central banks’ emergency liquidity provision.




                                                        Institute of International Finance • July 2009   ■   89
     Commitment XXII: In line with the industry         Recommendation 40: The point has been
     letter of June 2, 2009, to the President of the    reached where international cooperation
     Federal Reserve Bank of New York, to the           and coordination should be put on a firmer
     extent that CDS contracts, OTC interest rate       footing. We recommend the development of a
     derivative trades, and OTC equity derivative       non-binding inter-governmental accord on
     trades are not subject to CCP clearing, they       financial markets and financial services.
     will be recorded in a trade repository to ensure
     appropriate transparency of the market.
                                                        Cross-Border Crisis Management
     Recommendation 37: The Basel Committee             and Financial Firm Resolution
     should develop further standards for               Regimes
     model validation and monitoring in rating
     agencies, especially for structured products.      Recommendation 41: The FSB, as a priority,
     There should be independent verification of         should develop a convention on cross-border
     rating agency processes of model validation,       crisis management. The FSB should develop
     governance, and monitoring by means of             a coordination and non-binding mediation
     a self-regulatory organization or a new            role in preparation of arrangements for
     independent international review body.             cross-border crisis management concerning
                                                        individual groups.
     Recommendation 38: The industry and the
     official sector should continue to work together    Recommendation 42: Cross-border crisis
     to build on the new foundations already            simulation exercises should be carried out on a
     developed to ensure high levels of transparency    regular basis and with strong participation by
     for securitization products and markets so         relevant authorities and market participants.
     that securitization can continue to play its
     important role in providing finance for key         Recommendation 43: Under the auspices
     asset classes.                                     of the G-20 and subject to coordination by
                                                        the FSB, criteria of burden sharing between
                                                        jurisdictions in the event of the need for
     Resisting Fragmentation of                         financial intervention should be agreed among
     International Markets                              the major countries.

     Recommendation 39: The FSB should,                 Recommendation 44: Under the auspices of
     together with the IMF, make addressing             the G-20 and subject to coordination by the
     fragmentation of the international financial        FSB, authorities, as a matter of priority, should
     market a permanent objective. This should          ensure that they have in place special regimes
     complement the FSB’s important task                for bank resolution:
     of ensuring enhanced cooperation and
     coordination among authorities.




90   ■   Restoring Confidence, Creating Resilience
They should have the power of early        In the context of the winding-up
intervention.                              of a cross-border financial firm,
On determination that an institution       the objective should be, subject to
is systemically significant, the winding-   preserving the integrity of the financial
up of such institution should have as a    system, to maximize outcomes for
primary objective the protection of the    creditors of the group as a whole. There
international financial system.             should be no discrimination between
In order to preserve market certainty      creditors on grounds of nationality or
and confidence, financial markets law        geographical location.
(for example, concerning settlement
finality, set-off, and collateral rights)
must be respected.




                                           Institute of International Finance • July 2009   ■   91

				
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